The European Central Bank 1788212940, 9781788212946, 9781788212953

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THE EUROPEAN CENTRAL BANK

Finance Matters Series Editors: Kathryn Lavelle, Case Western Reserve University, Cleveland, Ohio and Timothy J. Sinclair, University of Warwick This series of books provides advanced introductions to the processes, relationships and institutions that make up the global financial system. Suitable for upper-level undergraduate and taught graduate courses in financial economics and the political economy of finance and banking, the series explores all aspects of the workings of the financial markets within the context of the broader global economy. Published Banking on the State: The Political Economy of Public Savings Banks Mark K. Cassell The European Central Bank Michael Heine and Hansjörg Herr Quantitative Easing: The Great Central Bank Experiment Jonathan Ashworth

THE EUROPEAN CENTRAL BANK MICHAEL HEINE AND HANSJÖRG HERR

© Michael Heine and Hansjörg Herr 2021 This book is copyright under the Berne Convention. No reproduction without permission. All rights reserved. First published in 2021 by Agenda Publishing Agenda Publishing Limited The Core Bath Lane Newcastle Helix Newcastle upon Tyne NE4 5TF www.agendapub.com ISBN 978-1-78821-294-6 (hardcover) ISBN 978-1-78821-295-3 (paperback) British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Typeset by Newgen Publishing UK Printed and bound in the UK by CPI Group (UK) Ltd, Croydon, CR0 4YY

CONTENTS

Tables and figures Preface 1.

Introduction: European integration

2.

From the Bretton Woods system to European Monetary Union

3.

The Maastricht Treaty and the Stability and Growth Pact

4.

Structure, political and legal framework of the European Central Bank

5.

Preconditions for a stable monetary union

6.

The failure of the two-pillar strategy of the ECB and the revival of Wicksell

7.

Increasing economic fragility in the EMU before the financial crisis

8.

Monetary policy during the Great Recession

9.

Monetary policy and the escalation of the euro crisis until 2012

10.

The ECB holds the euro together

11.

The fiscal policy framework in the EMU: no partner for the ECB

12.

Financial market supervision, banking union and financial market regulation

13.

The Covid-19 crisis and its effects on the EMU

14.

Prospects for European monetary policy and EMU

Notes Bibliography Index

TABLES AND FIGURES

TABLES 7.1 10.1 10.2 12.1 13.1 13.2

Net financial assets by sector in selected EMU countries (% of national GDP), 2001 and 2009 The asset purchase programme of the ECB, monthly net purchases The asset purchase programme stocks, October 2019 (in € million) Capital requirements for banks in the EU (% of risk-weighted assets) Levels of fiscal impulse and deferrals/liquidity guarantees adopted in response to the Covid-19 crisis by 15 June 2020 (% of 2019 GDP) Private debt in selected EMU countries (% of GDP)

FIGURES 1.1 2.1 4.1 6.1 6.2 6.3 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10 7.11 8.1

Governance structure of EU and EMU Bilateral exchange rates against the US dollar for selected EU countries, 1970–2000 The organizational structure of the European System of Central Banks Annual growth rates of M3, consumer price index and real GDP in the EMU, 1999– 2019 Refinancing rates of the ECB and money market interest rate, 1999–2019 The euro–US dollar exchange rate, 1999–2020 Real GDP in selected EMU countries, 1998–2018 Long-term interest rates in selected EMU countries, 1989–2019 House prices in selected EMU countries, 1998–2018 Share prices in selected EMU countries, 1999–2019 Nominal labour compensation per hour worked in selected EMU countries, 1996–2018 Nominal unit labour costs in selected EMU countries, 1996–2018 Consumer price index in selected EMU countries, 1998–2020 Current account balances in selected EMU countries (% of GDP), 1998–2018 Budget deficit in selected EMU countries (% of GDP), 1998–2018 Government debt in selected EMU countries (% of GDP), 1998–2018 Main refinancing rate of the ECB and the federal funds rate of the Fed, 1999–2019 Total hours worked in selected EMU countries and the US, 1998–2018

8.2 8.3 8.4 8.5 9.1 10.1 12.1

Unemployment rates in selected EMU countries, 1999–2019 Balance sheets of ECB and Fed (% of domestic nominal GDP), 2003–19 General government structural budget balances (% of potential GDP) in selected EMU countries and the US, 1999–2019 Public investment (% of total gross capital formation) in the EMU, US and Germany, 1999–2019 Target2-balances of selected EMU countries, 2008–19 Credit to the private sector in the EMU (€ billion) and the US ($ billion), 1996–2019 European system of financial supervision

PREFACE

With the creation of the European Monetary Union (EMU) in 1999, the participating member states took a bold step towards further economic and political integration. The development followed the logic of European integration since the Second World War – start with economic integration and political integration will follow. However, the creation of a monetary union implies that member states are giving up national sovereignty and establishing supranational institutions. At the very least a supranational central bank is needed to manage the EMU’s monetary policy. The preparation for the implementation of monetary union was far from complete. The European Central Bank (ECB) was created but other powerful supranational institutions in the EMU were missing. A vacuum developed with insufficient institutions in the EMU to manage its macroeconomic development while reducing room for manoeuvre for macroeconomic policy at the national level. The history of EMU is a history of the ECB struggling with the incompleteness of the monetary union. Cooperation among states could have reduced the lack of institutions in the EMU. However, cooperation was insufficient and became interwoven with the struggle of different member countries to increase or defend their influence and enforce their own economic policy strategy. Germany as the biggest country in the EMU followed hegemonic ambitions. However, its power and willingness to stabilize the whole monetary union was incomplete. With this in mind, we analyse the history of the EMU and especially the policy and role of the ECB in the framework of macroeconomic management. The first draft of the book was finished in early 2020, just as the Covid-19 crisis hit Europe. We then added Chapter 13 to provide some analysis of the early response to the crisis – as far as this is possible in June 2020. We would like to thank Alison Howson for support and debates and for her encouragement to write this book. We also thank an anonymous reviewer for helpful comments. Last but not least, we thank Lukas Handley for his technical support. Michael Heine Hansjörg Herr

1 INTRODUCTION: EUROPEAN INTEGRATION

The idea of creating a borderless Europe, while preserving the cultural independence of the individual countries or regions, is centuries old. In recent history, the first moves towards political European integration date back to the early twentieth century, but the First World War put paid to any ideas of integration and left Europe divided. It was not until after the Second World War that the first serious attempt at European integration took place. The United States, in particular, strongly encouraged and supported economic and political integration in Europe, as a strong Europe provided a buffer to Soviet ambitions during the Cold War. The American European Recovery Program, also known as the Marshall Plan, made a considerable financial and political contribution to integration in the western part of Europe and included cooperation between the formerly hostile countries. A formal alliance between the main continental European countries became concrete in 1951 (in force 1952) with the foundation of the European Coal and Steel Community, signatories to which were Belgium, the Federal Republic of Germany, France, Italy, Luxembourg and the Netherlands. These six countries also founded the European Atomic Energy Community, including Euratom, as a joint international organization in 1957 (in force since 1958). In 1957 (in force 1958) the Treaty of Rome, the treaty establishing the European Economic Community (EEC) was agreed. The main focus of this agreement was on the stepwise reduction of customs duties between the member states and the common organization of agriculture. The customs union decided in the Treaty of Rome came into force in 1968. A further step towards integration took place in 1967 when the three previous agreements were merged to form the European Community (EC). These integration steps were accompanied by the expansion of the Community with the accession of new member states.1 At the monetary level, in the 1950s and 1960s, European integration took place under the umbrella of the Bretton Woods system signed in 1944 and established in 1946. The system implemented fixed exchange rates, which could only be changed by agreement of the member states. The US dollar became the world’s reserve currency. The International Monetary Fund (IMF) and the World Bank were founded as the Bretton Woods’ institutions. The system guaranteed stable exchange rates and a stable international monetary system until the end of the 1960s. The system collapsed in the early 1970s pushing the EC-countries into

a period of monetary instability. As a response the European Monetary System (EMS) was founded in 1979, which formed the monetary framework for the integration of the EC until the European Monetary Union (EMU) of 1999. In the EMS, Germany’s Deutschmark dominated the system and the Deutsche Bundesbank more or less dictated monetary policy for all EMS-member countries (see Chapter 2). After the Treaty of Rome, with the exception of the EMS, there were no further attempts to deepen integration for a long time. The EC was completely preoccupied with the enlargement process and there was no political mobilization for further integration. This changed in the mid-1980s. In 1986 (in force 1987) the European Single Act was passed. The aim of which was to create a common internal market by the end of 1992. Until then, the customs union formed the core of European integration, which excluded many sectors including the insurance and banking industry and transport to public tenders. The four (indivisible) freedoms to be implemented in the European Single Act were: 1.

Free movement of persons (e.g. abolition of border controls, freedom of establishment of firms and employment);

2.

Free movement of all services (e.g. liberalization of financial services and transport and communications sectors);

3.

Free movement of all goods (e.g. elimination of customs duties and non-tariff restrictions);

4.

Free movement of capital (e.g. liberalization of financial markets, elimination of existing capital controls).

By the end of 1992, all of the goals set out in the Act had been achieved. Jacques Delors, president of the European Commission from 1985 to 1995, was the main driving force behind monetary integration. In 1988, the heads of governments of the member states of the EC instructed Delors to chair a committee to draw up proposals for monetary integration.2 In April 1989, the committee presented the Report on Economic and Monetary Union in the European Community, known as the “Delors Report”. This provided a plan for a monetary union for the countries of the EC, which was to be established gradually. At the summit of EC heads of government in June 1989, however, the report was controversially received. According to Niels Thygesen (1989), one of the independent expert contributors to the Delors Report, the divisions were over its political and economic implications: “Behind the apparent defeatism of many British comments on the feasibility of economic and monetary union lies another, deeper concern … [would] government not feel unacceptably constrained by adherence to an economic and monetary union in implementing its policies?” (Thygesen 1989: 650f.).

Britain was not prepared to give up the freedom to follow its own economic policy. For Germany which dominated the EMS “the present EMS is in some respects so attractive from a German viewpoint that it may be difficult to persuade Germany to reform the system” (Thygesen 1989: 647). The establishment of an independent central bank, the clear objective of price stability in a monetary union and the proposal in the Delors Report for budgetary rules made the project more appealing for the Germans. France actively supported the plan for a monetary union in the Delors Report. It was obviously convinced that it would be able to compete successfully with Germany in a monetary union, having already lost much of its monetary policy autonomy to Germany in the EMS anyway. Italy and smaller EMS countries followed the French line. The plan to establish a monetary union followed the so-called “locomotive theory”. The locomotive theory, which most European politicians followed when deciding on monetary union, states that a common currency would create realities that would push for further integration and advance the formation of a European state. This followed the logic of European integration after the Second World War, which was always driven by economic integration steps. However, the locomotive theory is yet to be confirmed in the case of EMU – the resistance of member states to take further steps towards state formation, in addition to the ECB, has been too great. Some important integration steps took place, but so far the expectations of the locomotive theory have not come to pass. Criticizing the locomotive theory, the Deutsche Bundesbank has always favoured the “coronation theory”, in which a common currency should only be introduced after unification of economic and financial policy in the EU and after substantial political integration (Deutsche Bundesbank 2016: para 10). However, this has to be taken in the context of a Bundesbank that was not in favour of the quick realization of monetary union. The revolution in the German Democratic Republic, the fall of the Berlin Wall in November 1989 and East Germany’s accession to the Federal Republic of Germany in 1990 burst in on this debate over monetary union. German unification undoubtedly accelerated the realization of the EMU. Until then, political decision-makers had been extremely cautious. Karl Otto Pöhl (Voxeurop 2010: para 7), then president of the Deutsche Bundesbank, said of the currency reform: “I was convinced that wouldn’t come for another hundred years”. France’s president at that time, François Mitterrand, stated: “Germany can only hope for reunification, if it stands in a strong Community” (Voxeurop 2010: para 9). In contrast to the United States, other countries, such as the UK and Italy, were sceptical about German reunification. Without a doubt, the EMU would not have been realized so quickly, nor existed in this form, without the developments in Germany. In effect, Germany accepted French demands for monetary union in exchange for unification (Black et al. 2018: 28 ff.; van Middelaar 2019). In February 1992 (in force since 1993) the Maastricht Treaty was signed, and the creation of a monetary union was decided. It was then established at the beginning of

1999 (see Chapter 2). In 1992, the EC was renamed the European Union (EU). From a narrow economic perspective, nation states are defined by their own currencies. If they do not have a national currency, they are a region in a currency area. By implication, the decision to create the EMU was a major step towards deeper integration and not comparable with the previous gradual evolutionary integration process in Europe. The importance of this fact cannot be underestimated, and it will be dealt with intensively in the following chapters. In addition to monetary union, the Maastricht Treaty established two further pillars of integration: the Common Foreign and Security Policy and cooperation in Justice and Home Affairs. There was little further development of either pillar, which reflects the philosophy of the Maastricht Treaty not including a vision of a European state. EU enlargement also continued.3 In early 2020, 19 member states had adopted the euro. The creation of a monetary union like the EMU implies a radical reduction of national sovereignty. Different dimensions play a role here (Cohen 1998). First, a national currency is a national symbol and part of national identity. Hans Tietmeyer, president of the Deutsche Bundesbank from 1993 until 1999, expressed this for the Germans: “The German people have a broken – interrupted – relationship with their own history. They can’t parade like others. They can’t salute their flag with the same enthusiasm as others. Their only safe symbol is the Mark” (quoted in Cohen 1998: 37). Second, to give up the national central bank means losing possibilities of seigniorage: the government no longer benefits from the profits made by the central bank. For currencies with an international role, seigniorage creates substantial benefits for governments. Third, national governments lose a lender of last resort for public households. In times of great need, they cannot rely on a central bank to provide financial means in crises situations. In several chapters that follow we show that this point has played an important role in the short history of the EMU. Finally, a national currency increases the freedom of national macroeconomic policy. It allows depreciations or a nationally oriented interest-rate policy. Of course, the room for manoeuvre for national macroeconomic policy depends on the openness of a country and especially the openness of the capital account and the international role of the currency. Even with high capital mobility, in developed countries with their own currencies, for example Sweden, the UK or Canada, some room for monetary policy exists, which nations in a currency union do not have. A number of treaties followed, with the Lisbon Treaty of 2007 (in force 2009) being the most important.4 The Treaty transferred limited rights to the EU level. Among other things, the application of qualified majority voting (QMV) for certain decisions was introduced. The rights of the European Parliament were also strengthened. Despite these integration steps, the EU continues to operate more as a confederation of states than as a federal one. In a confederation of states, the sovereignty of the member states is preserved. Although they can transfer rights to a central level, they can also withdraw them and even withdraw from the confederation entirely, for example, as the UK has done. In the

case of federal states such as the United States, individual states join together to form a sovereign federation, whereby the relations between the federal state and the member states are legally regulated. In this case, the central state assumes certain overarching competencies such as defence, internal security, diplomatic representation and international trade agreements. It regulates the tax system and collects its own federal-level tax revenues. Central government institutions also determine monetary and fiscal policy. There is no such central state in the EU, and there are no strong independent institutions at a central level – except for the European Central Bank (ECB). The power centre of the EU is the European Council (see Figure 1.1). The European Council website states: “The European Council defines the EU’s overall political direction and priorities” (European Council 2019). Only the heads of government of the EU member states vote in the European Council. Since 2009 the European Council selects a president for a two-and-a-half-year term. For specific areas there are the European Councils of Ministers, for example, the important Economic and Financial Affairs Council (ECOFIN) with the finance and economics ministers of the EU countries, the European Forestry and Environmental Skills Council, etc. Votes in the Councils are in many cases majority decisions, whereby 65 per cent of the EU population and 55 per cent of the EU member states are needed to achieve a majority. Decisions in the so-called sensitive areas must be made unanimously, for example on common foreign and security policy, EU finances or harmonization in the area of tax law or social security. It goes without saying, therefore, that there is no common army or police force in the EU. The member states are also responsible for their own social security. For example, there is neither a European pension system nor a European unemployment insurance scheme.

Figure 1.1

Governance structure of EU and EMU

Although the European Parliament is directly elected by the EU population, it has no exclusive legislative competence as normal national parliaments do. Laws, called directives, can only be passed jointly with the European Council. If there is no agreement, the draft laws are not implemented. However, the European Parliament has the right to be consulted on a number of issues. The members of the European Commission (ECo) are proposed to Parliament by the European Council. Parliament can only reject the ECo proposed by the Council as a whole – and not individual commissioners. The ECo has mainly administrative tasks such as monitoring directives. It can also introduce its own legislative initiatives. Finally, the European Court of Justice monitors and interprets European laws. The ECo manages the EU budget, but neither it nor the European Parliament can issue taxes. This means that the EU central level cannot issue government securities or otherwise

borrow to finance budget deficits. An anti-cyclical fiscal policy at the central level is thus ruled out. EU financing is essentially based on transfers from member states.5 The EU central budget stagnated at an average value between 2014 and 2020 of around 1 per cent of the EU’s gross domestic product (GDP), with a downward trend – during the 1990s the value was around 1.25 per cent. The EU central budget must be adopted unanimously by the member states after obtaining the consent of the European Parliament. In terms of 2014–20 expenditure, the agricultural sector accounted for 39 per cent, followed by the cohesion fund (34 per cent) and expenditure to increase competitiveness (13 per cent) (EU 2018). By comparison, the central budget in the US accounts for over 20 per cent of GDP (US Government Publishing Office 2019). With some exceptions, the EMU’s governance structure is integrated into the EU governance. The big exception is the central bank of the euro area. The ECB is an extremely powerful institution at the central level of the EMU and as such can make its own decisions. But because in the EU there is no fiscal power in the EMU, it has no separate central budget. In this regard, EMU-countries are normal members of the EU. The EMU is therefore in a unique historical position: in the field of monetary policy it has the character of a nation state, but in almost all other areas it does not. With the establishment of the EMU, the “Eurogroup” was created. It consists of the finance or economics ministers of the countries belonging to the EMU. Since 2005, the Eurogroup has elected a president for a two-and-a-half-year term. The Eurogroup has no formal powers and cannot enforce decisions. However, the informal power of the Eurogroup is significant as it dominates the European Council. For example, it monitors the budgetary policies of the EMU countries and important economic policies concerning the EMU are discussed there. The ECB is the most powerful supranational institution in the EMU. In the Governing Council of the ECB, each governor of the national central banks has a seat. The European Council appoints a president, a vice-president and four directors of the ECB’s Executive Board. All members of the Executive Board belong to the Governing Council of the ECB (for details see Chapter 4). The EMU has not led to the formation of a European state. Political power lies with the European Council and, respectively, the Eurogroup. The EU/EMU structure is flanked by an immense number of intergovernmental agreements designed to compensate for the lack of a genuine supranational authority. The governance system of the EU and the EMU is between an intergovernmental and a supranational governance system, as the European Council and the Eurogroup are the power centres of the system. For the EMU this kind of “middle system” has been strengthened by specific EMU institutions which were created after the 2007/08 financial crisis to handle its consequences (Polster 2019). The analysis in the following chapters of the ECB, its monetary policy and the EMU will show that the lack of a

supranational governance system poses a fundamental problem for the ECB and the stability of the EMU as a whole. Following this brief overview of European integration, we will examine the ECB, its policies and their interactions with other macroeconomic policies in the eurozone in more detail. We start with the turbulence in foreign exchange markets after the collapse of the Bretton Woods system and Europe’s policy attempts to return to monetary stability via the EMS. Chapter 3 explores the Maastricht Treaty with particular reference to the creation of the ECB and EMU. The analysis of the organizational structure of the ECB and its official objectives and instruments is covered in Chapter 4. The political and economic preconditions for a functioning monetary union are discussed in Chapter 5. Chapter 6 analyses the twopillar strategy of the ECB and its failure. The increasing economic fragility in the EMU before the outbreak of the financial crisis in 2007–08 is the content of Chapter 7. In Chapters 8–10 the ECB’s policy following the outbreak of the financial crisis up to 2020 is discussed in detail. Chapter 11 provides a brief overview of the reforms in the EMU in the area of fiscal and other policies after the financial crisis. Chapter 12 focuses on the banking union and financial market regulation following the financial crisis. Finally, the last chapter summarises the current situation in the EMU and outlines scenarios for future developments. At various points, comparisons are made with the Federal Reserve System (Fed) in the United States. The aim of these brief digressions is to sharpen our understanding of common features in monetary policy, but also of the very specific situation of the ECB and EMU.

2 FROM THE BRETTON WOODS SYSTEM TO EUROPEAN MONETARY UNION

Exchange rate turbulence since the end of the 1960s It is well known that the Great Depression in the early 1930s was accompanied by a lack of cooperation among key countries, and devaluation races and trade wars that exacerbated the devastating crisis. After the end of the Second World War, the experience of this painful history led to a new international monetary order under the leadership of the United States, agreed upon at the Bretton Woods Conference in 1944. The countries participating in this system agreed to implement fixed exchange rates that could be adjusted in cases of high current account imbalances within the framework of political decisions. Participating countries fixed their exchange rate vis-à-vis the US dollar with a permissible fluctuation of ±1 per cent. It was their sole responsibility to defend the exchange rate. From the end of the 1960s, however, this system became increasingly unstable. Instabilities increased because international capital flows became more deregulated in the 1960s and the willingness of countries, including the United States, to defend the system eroded. In 1967 Britain suffered a balance of payment crisis and devalued sterling. In the following two years based on its high current account surpluses, Germany was particularly affected by high capital inflows and had to extensively intervene in the foreign exchange market, finally revaluing its currency. France also had to devalue the franc. In August 1971, US President Richard Nixon announced the suspension of the dollar’s convertibility of central bank dollar reserves into gold, effectively ending the Bretton Woods system. Attempts to save the system in the Smithsonian Agreement of 1971, for example by allowing fluctuation of the exchange rate of ±2.5 per cent around the central rate, created short-term stability but the system finally collapsed in 1973. With its breakdown, the relative stability of international monetary relations after the Second World War came to an end. Western Europe also lost its monetary umbrella under which European integration had developed during the 1950s. Figure 2.1 shows the instability of exchange rates after the collapse of the Bretton Woods system. During the 1970s the D-Mark appreciated around 50 per cent and then depreciated over 100 per cent. During the same period, the Italian lira depreciated around 50 per cent vis-

à-vis the dollar. The British pound showed huge depreciations and also appreciations vis-àvis the D-Mark. Belgium and the Netherlands kept almost stable exchange rates vis-à-vis the D-Mark. The value of the French franc developed in the first half of the 1970s in parallel with the D-Mark but then depreciated against the D-Mark. The monetary turbulences of the 1970s threatened European integration as trade and capital flows were seriously disrupted (Giavazzi & Giovannini 1989).

Figure 2.1 Bilateral exchange rates against the US dollar for selected EU countries, 1970–2000 Note: increase means depreciation. Source: Federal Reserve Bank of St Louis (2019); and Board of Governors of the Federal Reserve System (US) (2019).

In light of the instability of the Bretton Woods system, as early as 1969 a commission of experts was set up by the heads of government of the European Economic Community (EEC) under the leadership of Luxembourg Prime Minister Pierre Werner. The commission developed the Werner Plan. This plan provided for the gradual unification of economic policy by 1980 and the introduction of a monetary union. It is worthwhile mentioning that the Werner Plan envisaged a substantially greater transfer of power to the central level than the later Maastricht Treaty: “On the institutional plane, in the final stage, two Community organs are indispensable: a centre of decision for economic policy and a Community system for the central banks. These institutions … must be furnished with effective powers … The centre of economic decision will be politically responsible to a European Parliament” (Werner Plan 1970: 26). And: “As regards indirect taxes, the system of the value-added tax will be made general and a programme for the alignment of rates adopted … In the field of direct taxes, it will be necessary to standardize certain types of tax … It will also be necessary to initiate and

actively promote the harmonization of the structure of taxes on corporations” (Werner Plan 1970: 19f.). However, this plan was never implemented and was forgotten during the economic turbulence of the 1970s. The minimum solution was the creation of the “European Currency Snake” in 1972. The Snake limited the fluctuation margin within the Bretton Woods system of the currencies of the countries participating in the agreement to ±1.125 per cent. With the final collapse of the Bretton Woods system, these countries switched to bloc floating against other currencies, especially against the dollar. Germany, with the largest economy in Europe, a history of relatively low inflation, current account surpluses and revaluations became the head of the Snake. This meant that the other central banks had to defend their currencies against the DMark as part of bloc floating. When the Currency Snake was created, the six founding members of today’s EU belonged to it. The UK and Ireland joined the system in 1973. However, due to a sterling crisis, the UK, like Ireland, resigned in the same year. Denmark also became a member of the Snake for a short period of time. Italy had to leave the Snake in 1973. France followed in 1974, returned in 1975 and left again in 1976. At times Sweden and Norway were associate members of the Snake. Overall, the Snake did not lead to stability. The economic turbulence in Europe during the 1970s showed that countries can have major problems in defending exchange rates against an anchor currency. Furthermore, it became clear that under certain constellations flexible exchange rates do not substantially increase the scope for a nationally oriented monetary policy. After the end of the Bretton Woods system, a whole series of European countries were confronted with devaluationinflation spirals. Devaluations led to a rise in domestic price levels, with the consequence of falling real wages. To compensate for this, nominal wages rose. This, in turn, drove inflation to higher levels. Eroding confidence in these currencies stimulated capital exports and further devaluations. In order to stop these disastrous spirals, countries had to resort to extremely restrictive monetary policy. The result was a costly stabilization crisis, which stopped the erosion of the monetary system (Bilson 1979) but led to crises in the real economy and highlevels of unemployment. The restrictions on exchange rate policy do not mean that exchange rates cannot be an important instrument for economic adjustment. For example, when in a policy package a currency devalues and this is combined with stable nominal wages, real depreciation can be achieved. In a developed country with a low level of foreign debt in foreign currency and normal price elasticities of exports and imports, a real depreciation can help to stimulate domestic demand and reduce current account deficits. To sum up, the exchange rate turbulence of the 1970s made it clear in Western Europe that stronger monetary integration was inevitable, which led to the European Monetary System (EMS).

The European Monetary System The EMS was founded in 1979, at the instigation of France and Germany. All six founding members of the EEC plus Denmark and Ireland participated at its launch. Other EU countries, including the UK and Ireland, joined the EMS in the late 1980s and early 1990s (Herr/Hübner 2005).1 The EMS stipulated that the member states would fix their exchange rates against the newly created European Currency Unit (ECU). The ECU, which could only be used by central banks, was a composite currency based on a currency basket of all the member countries, weighted according to each country’s GDP share. The ECU never circulated as currency, but it was to a minor degree used to index credit contracts. Each participating country fixed its currency against the ECU, with a permitted exchange rate fluctuation of ±2.25 per cent. Italy, the only exception, was permitted to fluctuate from the central rate by ±6 per cent. If a currency came under devaluation pressure, central banks had to intervene in foreign exchange markets. If, for example, a weak French franc threatened to exceed the agreed fluctuation margins against the D-Mark, the Banque de France had to buy up francs, with the help of its currency reserves, in order to stabilize the exchange rate. At the same time, the Deutsche Bundesbank had to buy up francs. In the short term, therefore, the central banks’ obligation to intervene was symmetrical. However, such symmetrical interventions were only implemented for short-term weaknesses of a currency. In our example, after a few months, the Deutsche Bundesbank had the right to present its French currency to the Banque de France, which had to relinquish its own foreign reserves to the Bundesbank. In the end, the intervention mechanism was asymmetrical and in the medium-term only the central bank of the weaker currency country was forced to adjust. If the exchange rate could not be defended despite such interventions, the central rate could be adjusted according to political agreements. In contrast to the Bretton Woods system, the EMS did not formally establish a leading currency. The latter was determined by the market and thus from the beginning, the D-Mark became the leading currency. As with the Currency Snake, the D-Mark had the lowest interest rates in the EMS and consequently determined the interest rates of the whole currency bloc. Other countries in the EMS had to defend their currencies vis-à-vis the DMark and adjust their interest rates accordingly. So, why did countries join the EMS in spite of the dominance of Germany and the Deutsche Bundesbank? The southern European countries, as well as France and the UK, had deployed permanent nominal devaluations as a blunt instrument to increase their own competitiveness. Regular devaluations led to inflation spirals and ultimately led to high interest rates due to low confidence in the currencies concerned. This, in turn, burdened economic growth. In contrast,

Germany was able to consistently defend its competitive position thanks to its significantly lower inflation rates and interest rates. A further complication for the weak currency countries during this period was that they were not in a position to offer the same stability as Germany. Other wage formation processes, different trade union cultures and unstable party systems prevented them from replacing Germany as the lead currency holder. In this context, it suited these countries to delegate monetary policy responsibility to the outside world and signal to domestic agents that inflationary processes would not be maintained (Giavazzi & Pagano 1988). In fact, from the mid-1980s onwards, the different inflation rates converged with Germany’s. The history of the EMS can be divided into four phases. From its foundation until 1983, there were seven realignments, as the inflation rates in the EMS were initially very different. For example, the inflation rate in Germany in 1979 was 2.7 per cent, whereas all other countries had significantly higher inflation rates, the highest being Italy’s at 12.1 per cent (OECD 2020). For domestic political reasons, too, countries within the EMS were under pressure. For example, after François Mitterrand’s presidential election in 1981, a socialistcommunist government was formed which followed a moderate Keynesian expansion policy. This triggered sustained flight of capital, which finally led to the break-up of the governing coalition in France and, in 1984, to the abandonment of the ambitious reform programme of the left-wing government. In the second phase from April 1983 to January 1987, there were only four realignments. In this phase, the EMS countries showed convergence in their inflation rates. In a third phase, up until 1990, there were no realignments. However, comparatively high current account imbalances in the EMS were built up during this phase. At the end of the 1980s, Germany had a surplus in its current account of around 5 per cent of GDP. In the UK the deficit was more than 3 per cent and in Spain about 3 per cent of GDP. Italy and France also realized smaller current account deficits during this phase (OECD 2020). The fourth phase began with German unification in 1990 and culminated in the EMU. Within the framework of German reunification, East Germany had considerable investment and consumption needs, which led to a “unification Keynesianism” and relatively high GDP growth rates in Germany because of high government spending. In 1990 Germany slipped from its balanced public budget in 1989 to a deficit of 3 per cent of GDP and remained at this level until 1996. Thereafter, the deficit was reduced to 1 per cent of GDP by 2000. Although the Kohl government attempted to reduce the budget deficits as early as 1992, this initially failed (Bibow 2001). The surge in demand, which concentrated on West Germany due to the collapsing industry in East Germany, also increased the inflation rate in Germany in 1992 to 5 per cent, which is high by German standards. Rising wage costs were a major contributory factor and the German current account became negative, presenting an unusual constellation for Germany.

During this phase of the EMS, the other countries were experiencing an economic crisis with rising unemployment. Despite the weak growth in these countries, the Deutsche Bundesbank reacted to the rise in the domestic inflation rate in a familiar manner by gradually raising the refinancing interest rate from 4 per cent at the beginning of the unification process to 8.75 per cent by mid-1992. This was a radical monetary policy which followed the traditional strategy of the Bundesbank to fight inflation hard and early. Obviously, the Bundesbank did not take into account the situation in other EMS countries. German monetary policy became an enormous burden for the other EMS countries. In order to defend the exchange rates against the D-Mark, central banks in the EMS had to raise their interest rates significantly despite their own domestic economic crises. Doubts developed as to whether these countries would politically be able to continue with restrictive monetary policy under these conditions. For example, in the UK in 1992 the unemployment rate jumped to over 10 per cent with increasing trend. In the absence of inflationary problems from the domestic point of view this demanded expansionary monetary policy. The aim of Prime Minister Margaret Thatcher to balance the public budget could not be realized as tax revenues decreased and expenditures caused by the crisis increased. In addition the high interest rates required for the UK to stay in the EMS became a burden for public households and private households with mortgages. Currency speculation exacerbated the crisis as it forced the Bank of England to increase interest rates further. Given that Thatcher’s interest in European integration was not overwhelming, this made speculation against the British pound promising. This increased the costs of defending the exchange rate. In the end, the UK and Italy decided to exit the EMS in 1992. As many of the remaining countries in the EMS also had problems in defending their exchange rates against the D-Mark, the fluctuation margins in the EMS were increased to ±15 per cent around the central rate in 1993. As a result, the EMS largely lost its function of stabilizing exchange rates. Despite this crisis in the EMS, EMU started on 1 January 1999 (Herr & Hübner 2005: 201ff.).

3 THE MAASTRICHT TREATY AND THE STABILITY AND GROWTH PACT

The Maastricht Treaty The Maastricht Treaty, adopted in 1992, should be considered against the backdrop of various historical developments and interests. Firstly, it was hoped that Europe, with the euro, would enjoy a stronger position in the international monetary system. In particular, experience with the Bretton Woods system had shown that, in case of doubt, the United States gave more weight to its national interests than to its responsibility for a functioning international monetary system. Secondly, the regular currency crises jeopardized the aim of creating a single European market, and the EMS had been unable to meet expectations in addressing this. Thirdly, the so-called weak currency countries in Europe had learned that the lack of credibility of their currencies in relation to the D-Mark led to significantly higher interest rates than those in Germany (see Figure 7.2). By transferring national powers for monetary policy to a supranational institution, it was believed that the credibility trap could be avoided and lower interest rates could be realized. Fourth, the southern European countries, as well as countries like France, had discovered that their monetary autonomy was limited and that monetary policy in Europe was largely determined by the Deutsche Bundesbank. The transfer of monetary policy to a supranational institution was thus not interpreted as a major loss, rather, it was hoped that in a supranational institution like a European Central Bank (ECB), monetary policy would be determined more democratically in Europe in the future (Brunnermeier et al. 2016). Germany’s interests were different. In a monetary union, it had to give up the dominant role of the Deutsche Bundesbank and the D-Mark as the regional reserve and key currency. The Deutsche Bundesbank and parts of the German public were sceptical about a quick monetary union (see Chapter 1). But the upheavals in Central and Eastern Europe pushed Germany to compromise. A symbol of this development was the fall of the Berlin Wall in November 1989, which made the official German reunification in 1990 possible. Unification consolidated the German position in Europe, making it even stronger, which France, Italy and the UK regarded with mixed feelings. Their strategy was to integrate Germany more closely

into the European Community in order to avoid an independent German policy. Germany, on the other hand, tried to dispel the concerns of many other countries, which were against German unification, by accepting further steps towards integration. Without this political constellation in the late 1980s and early 1990s, the EMU would most likely have been created far later, if ever. One line of compromise was that the ECB in its legal and institutional framework would clearly reflect Germany’s ideas at that time. The ECB would become super independent, with no possibility of financing public households, and pursue the aim of low inflation rates as strictly as possible. The Maastricht Treaty was officially concluded in 1992 and led to the founding of the European Union (EU) and the decision to implement deeper integration.1 The philosophy of the Treaty made clear, however, that further integration should not lead to a “United States of Europe”, similar to the United States of America. No one signing the Treaty was interested in any comprehensive loss of national sovereignty. The Maastricht Treaty had three pillars. The core of the first pillar was the creation of a European Economic and Monetary Union (EMU), which involved a transfer of monetary sovereignty to the supranational level. The second pillar aimed at a common foreign and security policy and the third pillar at cooperation in the field of police and internal security. To date, there has been no relevant progress in integration in the last two pillars – at least not in the sense of transferring competencies to the supranational level. The first pillar was elaborated in detail in the Treaty. A phased plan for the establishment of the EMU, the ECB and a common currency, the euro, was adopted. In 1989, the heads of state and government had already agreed to the creation of independent central banks in all the member states of the European Community and the complete abolition of capital controls, which still existed in some member states. This first stage had to be implemented by 1 July 1990. As a second stage, in 1994 the European Monetary Institute (EMI) headquartered in Frankfurt was founded. It was tasked with the regulatory, organizational and logistical preparation of the third stage of EMU. The EMI was also intended to improve monetary policy coordination before the implementation of the EMU. The ECB, the successor of the EMI, and the European System of Central Banks (ESCB) were able to start work on 1 June 1998. The ECB was established as a subsidiary of the national central banks. Neutral observers at the time would certainly have expected the national central banks to be subsidiaries of the ECB, a model found in most nation states, but such a model was not established in the EU. Initially, this fact did not seem to be so important, but we shall see that it began to play an important role after the financial market crisis of 2007/08. The third stage was the introduction of the euro on 1 January 1999, when the exchange rates of the countries participating in the EMU were fixed without any possibility of adjustment and fluctuation and the euro was introduced as book money, for example for bank

deposits. Euro banknotes and coins came into circulation three years later and replaced the national currencies. The introduction of the euro was not a currency reform but a currency changeover. This means that all monetary assets, all contracts and current payments and all prices were converted in the same proportion on the basis of the fixed exchange rates. For the D-Mark, for example, the conversion rate was 1 euro = 1.95583 D-Mark. One D-Mark thus corresponded to 0.5113 euro. After the changeover to the euro, the D-Mark was no longer a currency in its own right and disappeared as cash completely in 2002. An important element of the Maastricht Treaty was the independence of the ECB. This reflected the interests of Germany and was in line with the neoliberal spirit of the times. For example, in the so-called Augmented Washington Consensus of the 1990s, an independent central bank and inflation targeting were part of the 20 economic policy guidelines (Rodrik 2005). An independent central bank was seen as an important guarantor of a monetary policy that aimed to achieve a low inflation rate as its primary goal. Irrespectively, a dependent central bank, such as the Bank of England, which was a Treasury department until 1997, would not have been possible in the EMU. Since there was to be no supranational political centre with a finance ministry of a federal state in the EU or EMU, the ECB could not become a state bank that supports a central government. Therefore, it was only logical that the ECB became politically independent. Against this backdrop, it was plausible for the founders of the EMU to accept that the ECB was strictly forbidden to finance public budgets of member states or support the EU central budget. The prohibition for the central bank financing of public budgets found its analogy in the no-bailout clause of the Maastricht Treaty. It states that neither the EU central budget nor the EMU member states are liable for the public debt of any member state of the EMU. The aim of this clause was to prevent an irresponsible fiscal policy by governments in EMU member states. It was assumed that this clause would lead to low budget deficits and low public debt and that financial markets would quickly punish governments that carried high budget deficits. A no-bailout clause is not convincing, however. If a member state of the EMU were to go bankrupt, this would undoubtedly have an impact on the financial markets of the EMU as a whole. For example, there may be contagion effects due to cross-border debt. Investors’ trust in public debt would erode with the result that speculation would take place against countries that are considered to be financially unstable. Also, the social and political consequences of a member state’s government collapsing would destabilize the EMU. If an over-indebted government in the EMU is cut off from the credit market, which is very likely in a crisis of confidence, it cannot pay its police, teachers and doctors, nor its soldiers or transfer recipients. Therefore, it is hardly conceivable that the EMU as a whole could allow a country to fall into complete chaos. The no-bailout clause in the EMU is therefore absurd. This has

also been recognized by policymakers who agreed to the Stability and Growth Pact in 1997. The purpose of the pact is to strengthen the monitoring and coordination of national fiscal and economic policies to enforce the deficit and debt limits established by the Maastricht Treaty (see below).

The Maastricht criteria The Maastricht Treaty also dealt with the question of which states could participate in the monetary union. Because bailouts were ruled out, only economically stable countries were allowed to participate. For this reason, convergence criteria were established, which had to be fulfilled by states in 1997 in order to join the EMU on 1 January 1999. In 1998 the criteria were checked and the EU heads of governments decided which countries could join the monetary union. These criteria are still valid today as conditions for the accession of states to the EMU: 1. The inflation rate must not be more than 1.5 per cent above the average of the three most price-stable EU countries. 2. The nominal interest rate for long-term government bonds must not be more than 2 per cent above the average long-term interest rate of the three countries mentioned under 1. 3. There must be no devaluation within the EMS during the past two years. 4. Annual net public debt must not exceed 3 per cent of GDP and the public debt must not exceed 60 per cent of GDP. With a higher value of public debt to GDP, a clearly declining tendency had to be discernible. These criteria were certainly not infallible in testing the suitability of candidates for a monetary union. This is illustrated by two examples. First, the price-level criteria indicated that the country in question was able to control wage developments and thus inflation rates in 1997 alone, but it remained to be seen whether the country’s labour market institutions were able to achieve this goal over the long term. The Maastricht criterion did not check the labour market preconditions for a stable monetary union, such as a common labour market with a joint EMU minimum wage structure, a coordinated wage-setting mechanism or sufficient regional labour market mobility. In this respect, for example, the EMU differs significantly from the United States. Second, the interest rate criterion was intended to test the creditworthiness of a country according to the assessment of the financial markets. However, the potential member states still had their own currency and central bank at the time of the review. Under these

conditions, a central government indebted in national currency could not become insolvent. In an emergency, the central bank would intervene directly or in the secondary market for government bonds and fulfil its function as lender of last resort for governments. Central banks could, therefore, bring down long-term interest rates easily with open market operations. A completely different constellation arises when a supranational central bank, such as the ECB, is not entitled to grant emergency loans in the event of an imminent liquidity or insolvency crisis to the government of an EMU member country. In this case, a state bankruptcy is within the realm of possibility. The interest rate criterion, therefore, did not test the case of a country as a member of the EMU; it tested countries acting in a completely different institutional environment. Surprisingly, all EU countries at the time, except for Greece, were able to meet the Maastricht criteria. The public debt criterion no longer played a role and the 3-per-cent criteria came to the fore. Some of the countries only met the criteria with the help of “creative accounting”. In October 1996, Germany’s Der Spiegel wrote: “With veiling and accounting tricks, the finance ministers are trying with all their might to trim their budgets to the Maastricht requirement of not borrowing more than 3 percent of the gross domestic product (GDP) in 1997” (Spiegel 1996: para 6).2 Although the Maastricht criteria were unsuitable for the task of testing whether countries could join a monetary union or not, many experts considered them to be tough enough that only a small EMU would start in 1999. However, the EMU launched with a large group of countries: all southern European countries with traditionally weak currencies wanted to participate. Germany and France as core countries had to join anyway. Politically it was difficult to deny countries membership. In the end, of the existing member states that wanted to join, only Greece could not fulfil the criteria. This means the founding members of the EMU were Germany, France, Italy, the Netherlands, Portugal, Spain, Belgium, Finland, Ireland, Luxembourg and Austria. The EMU was later joined by Greece (2001), Slovenia (2007), Cyprus (2008), Malta (2008), Slovakia (2009), Estonia (2011), Latvia (2014) and Lithuania (2015). In 2018, the EMU had a share of just over 75 per cent of US GDP calculated in purchasing power parity (the EU with the UK just over 91 per cent) (OECD 2020).

The Stability and Growth Pact (SGP) At the conclusion of the Maastricht Treaty, there was increasing scepticism over whether the fiscal criteria would be fulfilled by member states after the creation of the EMU. The nobailout clause did not seem to be sufficient to enforce budgetary discipline. Germany, in particular, advocated long-term arrangements for fiscal policy, with the aim of increasing the approval of its own population for the introduction of the euro. At a meeting with his

colleagues in 1996, German Finance Minister Theo Waigel urged that strict fiscal rules should apply for countries also after their entry into monetary union and that violations should be countered with sanctions. In 1997, the SGP was adopted for the members of the EMU. The name is misleading, as the SGP is only a pact to limit fiscal policy and has nothing to do with policies to stimulate growth. With the introduction of the SGP, it finally became clear that the EMU did not want to establish an active fiscal centre that would assume fiscal policy and other state functions. Instead, rules were established that would regulate, monitor and sanction the fiscal policy of the member states. In the SGP it was determined that going forward the annual budget deficit may not exceed 3 per cent of the GDP and public debt has to be limited to 60 per cent of GDP. Countries that were more heavily indebted should follow policies to approach the 60 per cent target. Some narrow exceptions were agreed. For example, the pact can be loosened temporarily in the event of natural catastrophes. This also applies in the event of a severe economic crisis, which is defined as a decline in GDP of at least 0.75 per cent per annum. As a guiding principle, public budgets should be balanced over the economic cycle to have some fiscal room in phases of low growth. The SGP also had a “preventive arm” for the monitoring of budgetary positions and fiscal coordination, and a “corrective arm” that could levy sanctions on countries that violated the rules. According to the SGP, if there is a danger that a member of the EMU will exceed the 3 per cent limit, the ECo can issue an “early warning” and write a “blue letter”. Should the rule nevertheless be violated, the ECo initiates an excessive deficit procedure. The countries concerned must present a plan on how they intend to reduce the budget deficit. If they fail to do so, they may be forced to make an annual interest-free deposit of 0.2–0.5 per cent of GDP in Brussels. If the deficit is not reduced, the deposit is converted into a penalty and entered in the EU budget. Significantly, the penalties are not imposed by the ECo, but only by the Economic Council (ECOFIN). Penalties require a qualified majority, but the country concerned does not have the right to vote. It is worth noting that Theo Waigel proposed an even sharper version of the SGP, but did not succeed. Encouraged by the Bundesbank, Waigel recommended that government deficit should not be allowed to exceed 1 per cent of GDP (as opposed to 3 per cent for accession) and that if a member state exceeds this threshold, the sanctions laid down in the Treaty should be applied automatically (CVCE 2019: para 2). The decision in favour of a subordinate role for fiscal policy in the EMU corresponds to the ideas of the (neo-)classical economic paradigm. The most radical variant of this school of thought is the theory of rational expectations. It is based on the assumption that if governments do not interfere and let the market work unfettered, the economy is always in equilibrium with full employment. According to this model, equilibrium is determined exclusively by supply-side conditions; aggregated demand plays no role. The decisive factor

in this assumption is that expectations in the models are set endogenously. Economic agents expect the equilibrium solution of the model, independent of how unrealistic these assumptions are.3 Under this condition, active fiscal policy is indeed ineffective and must be prevented. In the case of budget deficits, it is argued that economic agents curb their expenditures so severely as a precaution against future higher tax payments that aggregate demand does not increase at all. This makes fiscal policy ineffective even in the short term (Barro 1974; Lucas 1981). In the New-Keynesian models, the long-term equilibrium is also determined only by supply conditions, but price rigidities or other disturbances can prevent the equilibrium from being reached quickly. In these cases, fiscal policy, like monetary policy, can help to achieve equilibrium more quickly with full employment. However, in the medium or long term, fiscal policy plays no role here either. The public budget should, therefore, be balanced in the medium term. Both schools of thought were extremely popular in the 1990s at universities, research institutions and among the consultants of ministries, and they still are today. These ideas were the godfathers of the SGP. On a more concrete level, advocates of the SGP argue that budget deficit and increasing government demand for credit leads to rising interest rates and that in effect this pushes private demand out of the market. Another common argument is that high budget deficits lead to inflationary developments. Here it is assumed that budget deficits are financed via money creation by the central bank and that the increasing money supply then triggers inflationary processes. Arguments of the kind outlined above are not convincing since the assumed assumptions are by no means plausible. Why shouldn’t economic agents expect the additional government demand to lead to rising production and income? In this case, rational economic agents will increase their investment and consumer demand together with expansive fiscal policies. Equally nebulous is the thesis that private demand is automatically replaced by higher government demand resulting from budget deficits. This thesis assumes that output is given, independent of demand, a pot of savings exists and rising budget deficits necessarily reduce other uses of savings. In fact, however, expansionary fiscal measures can increase output and savings through the stimulation of production and income. It turns out that output is not given, independent of demand. Above all interest rates are also largely determined by the central banks. So why should a central bank raise its interest rates in case of active fiscal policy when production capacities are under-utilized and the inflation rate is low? In particular, the following points raise doubts about the SGP.4 First, the definition of maximum budget deficits of 3 per cent of GDP is without theoretical basis. A long-term budget deficit of 3 per cent can be too high for some countries and unjustifiably low for others. Countries with a very high growth rate can realize a high

budget deficit without increasing the public debt ratio. Conversely, if a country has a growth rate of zero or even negative values, then the debt ratio explodes with a permanent budget deficit of 3 per cent. If one takes the budget balance as a variable for a fiscal rule, then it would have to be adjusted specifically for the respective growth dynamics. The history of the 3 per cent rule is symptomatic of the lack of any theoretical foundation. It was invented by Guy Abeille, a civil servant in the French finance ministry in 1981. Mitterrand wanted a simple message to convince the public that his fiscal policy was sound. Abeille got the idea that a certain percentage of GDP would be simple and the 3 per cent of GDP fitted the French situation in 1981 giving France a bit more room for fiscal policy. Abeille says: “This was back then alone based on the circumstances, without any theory” (Frankfurter Allgemeine Zeitung 2013: para 4). The rule fulfilled its purpose for Mitterrand. During the negotiations of the Maastricht Treaty the French delegation remembered the rule and proposed it. Germany was in favour of a “golden rule of fiscal policy”. According to this rule in the longer-term, government consumption expenditure should be financed by taxes, whereas public investment can be financed by borrowing. But Germany could not convince the other member states. It was feared that public investment was too difficult to define and, for example, military or education expenditure could be financed as investment. Finally, the 3 per cent rule was agreed upon, still without theory, but mainly because it was pertinent to the French and Germany economic situations at that time (Frankfurter Allgemeine Zeitung 2013: para 4). Second, governments cannot control a budget deficit in the short term because economic downturns reduce tax revenues and increase social spending. In fact, the SGP tends to be procyclical. If the deficit limit is to be maintained in a downturn, the country in question may be driven to implement dysfunctional restrictive fiscal policy. Of course, it will achieve a partial reduction of the budget deficit, as GDP growth will be further weakened by spending cuts or tax increases. If a country violates the SGP, public investment is usually cut, as this is the easiest to reduce. In an upswing, on the other hand, the Pact provides no incentive to reduce budget deficits. Third, to prevent destabilizing fiscal policy, maintaining a government debt ratio is more important than a deficit ratio. This is because a very high debt ratio can be dangerous: in such a constellation, an increase in interest rates increases the interest burden ratio. This, in turn, can lead to an explosion of the budget deficit. In addition, high government debt can have negative redistributive effects if the poor pay interest via taxes and the rich hold government bonds. A certain optimal or maximum government debt ratio, however, cannot be theoretically determined. In 2017, for example, the government debt to GDP ratio was 49 per cent in Denmark, 72 per cent in Germany, 136 per cent in France, 136 per cent in the US, 153 per cent in Italy, 188 per cent in Greece and 234 per cent in Japan (OECD 2020). From this measure alone one might conclude that the US is in a precarious situation, which is clearly

not the case. Horn and Truger (2005) have proposed that if there should be a rule at all, it should be a stable growth path for government spending that is independent of the business cycle. It might be useful to fix a maximum value of public debt to GDP.5 If a country’s public debt ratio exceeds the specified norm, the growth rate of non-cyclical government expenditure should be below the medium-term GDP growth rate in order to achieve a reduction in the debt ratio in the long term. If according to the SGP philosophy, a balanced state budget is to be achieved over the business cycle, then the national debt as a percentage of GDP would fall in a growing economy to very low levels. This would not be a preferable result. A targeted government debt ratio should not be too low because a certain volume of safe government bonds meets the portfolio preferences of parts of households, insurance companies and other investors. A golden rule of fiscal policy with high and stable public investment could be a potential rule. Under no circumstances, however, should anti-cyclical fiscal policy be restricted. Keynes made an additional proposal. He assumed that if long-term growth weakened, neither monetary nor fiscal policy would be able to overcome the crisis. He wrote (1936: 378): “I conceive, therefore, that a somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment”. In his opinion, a large public corporate sector, semi-state institutions or cooperatives (such as housing cooperatives) would be necessary to stabilize the growth dynamics of capitalist economies. Finally, it must be stressed that a monetary union requires binding agreements and cooperation between the member states in order to achieve a functional fiscal policy in terms of economic policy and to prevent free-riding. However, this is extremely difficult in the absence of a strong fiscal centre, as in the EMU. In any case, the SGP is in no way in a position to ensure a functional fiscal policy in the EMU. It has indeed already failed in its first test (see Chapter 7).

4 STRUCTURE, POLITICAL AND LEGAL FRAMEWORK OF THE EUROPEAN CENTRAL BANK

The organizational structure of the European System of Central Banks The structure of the European System of Central Banks (ESCB) complies with the provisions of the Maastricht Treaty. Since there was to be no “United States of Europe”, there was no political centre which, as in most nation states, could have become the owner of the ECB. Consequently, the ESCB was chosen as the mechanism for control and the ECB was founded as a subsidiary of the national central banks of all EU member states, which had to raise the equity capital for the ECB. That all EU member states became owners of the ECB was a clear sign that the EMU was being thought of as a project for the whole EU. The equity share depended on two determinants with equal weighting. Each EU member had to provide a proportionate share of equity dependent on its population share in the EU. The other 50 per cent was calculated on the basis of the national share of each country in the EU’s GDP. The shares are regularly reviewed and adjusted. At the beginning of 2019, for example, Germany had 18.4 per cent, France 14.2 per cent and Estonia 0.2 per cent of the ECB’s equity capital (ECB 2019e). Profits and losses of the ECB are according to the capital share only distributed to the members of the EMU. Figure 4.1 gives an overview of the structure of the ESCB. The General Council of the ESCB comprises the president and vice-president of the ECB and the governors of the central banks of all EU member states. The other members of the ECB’s Executive Board, a member of the ECo and the president of the European Council can participate in meetings but are not allowed to vote. The governors of the national central banks are appointed by the institutions of their respective countries. In Germany, for example, the president of the Deutsche Bundesbank is appointed by the federal president on the recommendation of the federal government. Although monetary policy issues are discussed in the General Council, it does not make decisions in this arena, nor regarding other important topics concerning the EMU. It performs administrative functions such as the establishment of the necessary rules for standardizing the accounting and reporting operations undertaken by member national banks or decisions about the conditions of employment of the staff of the ECB.

Figure 4.1

The organizational structure of the European System of Central Banks

The important body in the EMU in which monetary policy decisions are taken is the Governing Council of the ECB. It consists of the members of the ECB’s Executive Board and the governors of the national central banks of the countries participating in the EMU. In order to restrict the number of voting members of the Governing Council, a complicated monthly rotation procedure was introduced, similar to that at the US Federal Reserve. The countries are currently divided into two groups. The first group includes the EMU countries with the greatest economic power and the largest financial sector. These are Germany, France, Italy, Spain and the Netherlands. These five countries rotate to have four votes; this means one of the countries has in a certain week no voting power. The remaining 14 countries currently rotate in such a way that they have 11 votes. However, all governors of the euro area national central banks have the right to speak at any Governing Council meeting, even when not having the right to vote. The Executive Board of the ECB consists of the president, vice-president and four additional members. It implements the resolutions adopted by the Governing Council. The members of the Executive Board are selected and appointed by the European Council, i.e. the heads of state and government, by a qualified majority (see Chapter 1). The non-renewable term of the members of the Executive Board of the ECB is eight years.1 In formal terms, there are major similarities between the ECB and the Federal Reserve System (Fed) (for details, see Fed 2019b). The Fed was established in 1913 by the Federal

Reserve Act after a series of bank runs. The Board of Governors of the Fed, based in Washington DC, is comparable to the Executive Board of the ECB. The Board of Governors consists of the president and the vice-president and – in this case – five other members. They are all nominated by the US president and approved by the Senate. The members of the Board of Governors are appointed for a term of 14 years. The most important monetary policy decisions in the US are taken by the Federal Open Market Committee (FOMC), which decides on the Fed’s open market operations. The decisions on the discount rate and reserve requirements are taken by the Board of Governors. The FOMC has similarities to the Governing Council of the ECB. While the FOMC consists of the Board of Governors and five governors of the regional Federal Reserve Banks, the Governing Council of the ECB is composed, as described above, of the members of the Executive Board and the governors of the 19 national central banks of the EMU. Apart from the Federal Reserve Bank of New York, which always has a voting right in the FOMC, the other regional Federal Reserve Banks rotate and always only four have a voting right in the FOMC. The 12 regional Federal Reserve Banks appear to correspond to the 19 central banks of the euro area. However, the regional Federal Reserve Banks are owned by some 3,400 banks located in the region. The Fed as the central institution is in turn owned by the 12 regional Federal Reserve Banks. Each of these banks has nine directors. Six of the directors are elected by member commercial banks. Three of the directors are appointed by the Board of Governors of the Fed. From among these three, the Board of Governors selects a chairman and a deputy chairman. In the case of profits of the regional Federal Reserve Banks, the private owners first receive a dividend of 6 per cent of their paid-in capital on the grounds that they must hold statutory minimum reserves without interest. All excess profits of the entire Federal Reserve System flow into the central budget in Washington. In the euro area, central banks are purely public-sector entities. It is often argued that the Fed’s ownership structure means that the influence of the private banking sector on monetary policy in the US is more pronounced than in the EMU. We do not follow this argument. In the Fed, the power of the politically determined Board of Governors over the FOMC and the regional Federal Reserve Banks is sufficiently great to minimize the influence of the owners of the Fed. Lobbying by the financial sector beyond the ownership structure is likely to play a greater role both in the EMU and in Europe. These similarities must not obscure a fundamental difference between the two systems. The Fed, like almost all other central banks in the world, is the central bank of a nation state with the corresponding responsibilities and competences. As a result, the Fed has a “cooperation partner” in the US federal government, even if cooperation does not always run smoothly. Such a system does not exist in the euro area. The consequences, which we will discuss in more detail below, can be illustrated by two examples.

First, the Fed guarantees the financing of the US public budget at all times, so that the US federal government cannot become insolvent in domestic currency. This is in line with the Fed’s role as lender of last resort, in which it ensures not only the liquidity of the banking sector but also the liquidity and solvency of the government. Even if a lender of last resort is not mentioned explicitly in the legal regulation of the central bank or that the central bank is not allowed to finance public households, in crises situations the central bank can buy government bonds in the secondary market or refinance commercial banks, which in turn give credit to public households. In the euro area a lender of last resort for public households is not guaranteed. For the governments of the EMU member states the euro is a currency that they cannot produce themselves, so they can, in fact, become insolvent in their “own” currency. This has been impressively demonstrated in the crises in 2010. Second, the ECB lacks a central fiscal policy partner with whom it can pursue a coordinated economic policy and, if necessary, rescue financial institutions and even large companies. In the eurozone, for example, the absurd situation that arose from 2008 onwards was that monetary policy was increasingly relaxed in order to prevent an economic and political catastrophe. At the same time, Germany, in particular, exerted massive pressure on the individual member states to force them to adopt partly extremely restrictive fiscal policies. The result of this dysfunctional non-cooperation was the unsatisfactory economic development for the eurozone after the Great Recession.2

The independence of central banks and the ECB Central banks were, with a few exceptions, traditionally departments of their country’s ministry of finance or economics. This changed with the neoliberal turnaround in economic policy in the 1970s and 1980s, after neoliberal ideas gained influence in economic science. Monetary policy was seen as being better left in the hands of independent technocrats than in the hands of politicians. According to the (neo-)classical view, money is neutral – at least in the long run. For this reason, a central bank only has to provide a stable framework for a market economy in the form of a stable rate of price change. If politicians gain influence over monetary policy, the argument goes, they will tend to use monetary policy to stimulate economic growth or prevent needed restrictive monetary policy especially before election time despite long-term negative effects. In this context, the argument of time inconsistency became popular (Kydland & Prescott 1977). Based on the neoclassical paradigm, a monetary policy that promises a low stable inflation rate is optimal for economic development. Once the promise has been made, however, it seems optimal for policymakers to increase the inflation rate because a higher inflation rate leads temporarily to higher employment. In order to prevent such short-term motivated policies, an independent central bank is essential.

Such assumptions about the motives and conduct of politicians cannot be claimed as universally valid. For example, it is not always true that democratically elected governments are punished more severely by high unemployment than by high inflation rates during elections. Since inflationary developments, unlike unemployment, affect the entire population, it is by no means self-evident that governments should draw the inflation card in order to improve the employment situation. Moreover, the argument that higher inflation rates lead automatically to higher employment is anything but uncontroversial. So why should politicians always believe in a positive link between inflation and employment? The history of central banks shows that the dependence of central banks and higher inflation is not mechanically correlated. In the past, countries such as Japan, Austria, Sweden or the Netherlands had low inflation rates despite dependent central banks (Bofinger 2001: 220f.). In recent modern history central banks were usually directly managed by finance ministries, which decided about monetary policy. The Fed was an exception. It was established in 1913 by the Federal Reserve Act as an independent institution and had its own decision-making body. However, the president of the Fed’s governing board was the Secretary of the Treasury. In addition a second person from the Treasury automatically belonged to board.3 This changed in 1935 when, in an amendment to the Federal Reserve Act, the FOMC was created with no seats for government representatives. However, independence of the Fed existed only on paper. When Roosevelt became US president in 1933 he used emergency rules to control monetary policy. The Fed was in effect continuously dominated by the Treasury during the Second World War. Only in the early 1950s did the Fed become more independent, due to the Korean War. During that conflict the FOMC rejected the government’s demand that the Fed should buy unlimited government bonds without increasing the interest rate. In this conflict the Fed gained more independence. However, close interaction between the Fed and the US Treasury continues with different degrees of government influence on monetary policy decisions (Slivinski 2009). Influenced by the monetary constitution of the US, the German central bank, the Bank of German States, was founded in 1948 and from 1957 the Deutsche Bundesbank became an independent institution. Almost all other central banks in Western countries were directly managed by finance ministries or treasuries. Most of them subsequently became independent in the 1990s. The central banks of the later euro area countries had to become independent in the early 1990s as a result of the Maastricht Treaty. The Bank of England and the Bank of Japan followed as late as 1997. In the Augmented Washington Consensus of the 1990s an independent central bank became one of the recommendations in the field of institution building (Rodrik 2005). The independence of central banks has different dimensions and degrees. These will be examined in more detail below, with particular reference to the ECB.

Prohibition of direct financing of public budgets The independence of central banks could not be guaranteed if central banks can be forced to lend to public budgets. Therefore, the ECB is strictly prohibited from lending to central, regional or local governments or to public enterprises or other institutions governed by public law. In addition, it may not purchase government debt directly on primary markets.4 This applies in a similar way to the Fed, which is not permitted to buy securities directly from public authorities.5 What reads so innocently here, however, has fundamentally different consequences for the Fed and the ECB. The Fed can buy any number of debt securities issued by the federal government and securities issued or guaranteed by governmentsponsored agencies in the secondary market and directly from the manageable number of slightly more than 20 primary dealers. The Fed can take over the function of lender of last resort for the US central government without any problems, without limits or issue. The central government, in turn, can act as a lender of last resort for lower government levels. The ECB has, as mentioned several times, no central government partner and cannot buy debt-securities from such a partner. Buying debt-securities issued by the governments of the EMU member states is common practice at the ECB, but it is not possible for the ECB to freely finance those governments that are in dire financial straits. In the EMU constitution there was what C. A. E. Goodhart (1995: 452) calls, no institution which provides “revenue of last resort”. After the crisis of 2008/09, the EMU member states without financial problems in their public budgets, such as Germany, were extremely concerned that the ECB did not take over the function to provide revenues of last resort for single member countries or the ECo (see Chapter 9). This destabilized the whole EMU. Only under extreme crisis pressure was the ECB allowed to support single member states of the EMU (for example during the Covid-19 crisis, see Chapter 13).

Personal independence Article 108 of the EC Treaty stipulates that members of the Governing Council may neither accept nor seek political instructions. The members of the Governing Council of the ECB are selected by their respective national governments (governors of the national central banks) and by the European Council (members of the Executive Boards). As a result, the nomination process and appointment of the members of the Governing Council is politically decentralized and complex. This makes it almost impossible that the government of one member country can dominate the Governing Council. Furthermore, the independence of members of the Governing Council is further enhanced by the relatively long terms and staggered duration of the contracts and the ban on re-election. In the US, the central

government appoints the Fed’s Board of Governors. This, in turn, has the majority in the FOMC and appoints the governors of the regional Federal Reserve Banks. Duration of the appointment of members of the Board of Governors is long. Overall, political change in the US can affect the Fed much more quickly than in the ECB with its much more decentralized appointment procedure.

Financial independence Like the Fed, the ECB is financially independent. Both central banks finance their expenses via the surpluses they generate. The ECB’s budget is not part of the EU’s general public budget. The finances of the ECB are audited by an independent auditor.

Target independence Different central banks can, according to their constitution, have different objectives. The ECB was given an overriding economic policy objective. In Article 105 of the Treaty Establishing the European Community (2002) it is written: “The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community.” The ECB has the right to define price stability. In January 1999, it defined an inflation rate between zero and 2 per cent and since 2003 an inflation rate close to but below 2 per cent as price stability (ECB 1999, 2003) (see Chapter 6). During negotiations to establish the EMU the later member countries had quite different ideas about the objectives of monetary policy (Brunnermeier et al. 2016). While, for example, Germany and some smaller northern European countries accepted only price level stability as the primary objective of monetary policy, the southern European countries and France preferred also to aim for high levels of employment or high economic growth as objectives of monetary policy. Germany and its allies succeeded in winning the argument. To define a low inflation rate as the primary objective of central banks became popular along with the independence of central banks. For example, central banks in the UK, Japan, Switzerland and Sweden also have a low inflation rate as a primary target. The inflation target of a central bank can also be determined by the government. The UK is an example of this. The Fed pursues a different line, with a stable price level, a maximum level of employment and moderate long-term interest rates as its goals. With regard to the inflation target, the Fed had long refused to fix it in quantitative terms. This changed in January 2012 when the Fed announced an official medium-term inflation target of 2 per cent.

Exchange rate policy Like all central banks in the world, the ECB can intervene in the foreign exchange market and thereby influence the exchange rate of the euro. This can be done alone or together with other central banks. The ECB can also introduce external capital controls in an emergency. The ECB has no right to conclude formal exchange rate agreements with other countries; this is the responsibility of the Economic and Financial Affairs Council (ECOFIN). The ECB is merely consulted. In addition, ECOFIN “can formulate general guidelines for the Eurosystem’s exchange rate policy” (ECB 2019g: para 11). These cases have not occurred since the existence of the ECB. It is unclear to what extent ECOFIN can issue guidelines for exchange rates if the ECB sees the goal of price level stability endangered by the resulting intervention obligations.

Instrument independence In essence, instrument independence means that the ECB can independently control the way in which it interacts with commercial banks. Articles 18, 19 and 20 of the Protocol on the Statute of the European System of Central Banks and of the European Central Bank (ECB 2019f) lay down the basic principles for how monetary policy instruments are to be used. The concrete usage of the instruments is decided by the ECB. The ECB is also allowed to use other instruments under certain conditions. In the following, we describe the most important monetary policy instruments of the ECB, which are used with modification by all modern central banks in developed countries (ECB 2008c, 2019h). At the heart of the ECB’s conventional monetary policy is the open market policy with the main refinancing operations, which the ECB conducts on a weekly basis and which aim to control the money market interest rate. In the euro area, the measure for the money market interest rate is the EONIA (euro overnight index average), i.e. the interest rate demanded by financial institutions for short-term loans to other financial institutions. The ECB estimates the refinancing requirements of the banks and determines the volume of central bank money that is to be created via the main refinancing operations. The ECB only refinance commercial banks that can deliver collateral. To this end, it draws up a list of eligible assets. These may consist of marketable assets such as government or private debt-securities, but also non-marketable assets such as private debt-securities, which do not have a secondary market. If the commercial banks require an increase in refinancing volume, the quality of eligible assets can be reduced. To conduct open market policy, the ECB buys interest-bearing securities from the commercial banks, usually government bonds, but also interest-bearing assets from the private sector without secondary

markets. At the same time, both parties agree that the banks repurchase the securities usually after one week. In these open market operations with repurchasing agreements (repo agreements) the difference between the purchase price and the sale price expresses the interest rate that the ECB charges for the provision of central bank money. When the central bank buys securities and respectively gives credit, central bank money is created out of nothing. When securities are bought back and respectively credits are paid back, central bank money is destroyed. If the central bank wants to influence long-term interest rates directly, it can carry out longer-term financing operations. These are carried out on a monthly basis and the maturity of these repo agreements is three months. In the wake of the 2007/08 crisis, the ECB increasingly concluded longer-term refinancing operations. The maturities of these loans have been repeatedly extended, initially to six months, then to 12 months, from the end of 2011 to three years and from 2014 even longer. Another variant of the open market policy are fine-tuning operations, with which the ECB reacts to unexpected events in order to keep the money and financial markets stable. The open market operations are flanked by standing facilities. In the event of liquidity shortage, commercial banks can obtain unlimited overnight credits against collateral in the so-called “open discount window”. The interest rate for these loans is slightly higher than that for the main financing transactions. Since the volume of credit on the discount window is unlimited, this interest rate also forms the upper limit of the interest rates on the money market. With the deposit facility, excess liquidity on the money market can be deposited with the ECB as overnight deposits. The interest rate for overnight deposits is lower than the interest rate for main refinancing operations and represents the lower limit for the money market interest rate. In normal times, the ECB pays interest on these deposits at a positive rate. As part of its efforts to combat the Great Financial Crisis starting in 2007 and escalating in 2008, however, the ECB waived interest rates and even introduced negative interest rates in 2014 in order to stimulate the lending business of commercial banks (see Figure 6.2 in Chapter 6). One of the traditional instruments of monetary policy is minimum reserve policy. This obliges commercial banks to deposit a certain percentage of their deposits with the ECB in central bank money. “The intent of the minimum reserve system is to pursue the aims of stabilising money market interest rates and creating (or enlarging) a structural liquidity shortage” (ECB 2019h: para 5). In principle, minimum reserves have to be kept for overnight deposits, deposits with agreed maturity or period of notice up to two years, debt securities issued with maturity up to two years and money market papers. By creating a structural liquidity shortage in commercial banks by minimum reserve requirements, the ECB always has the power to determine short-term interest rates. This is the case even if cash in circulation completely disappears. For minimum reserve holdings, the ECB pays interest

according to the average interest rate of the main refinancing operations. This is done not to destroy the competitiveness of banks acting in the euro area vis-à-vis, for example, banks acting in offshore centres without minimum reserve requirements. In the course of the crisis, the minimum reserve rate was reduced from 2 to 1 per cent in 2012. The minimum reserves only have to be met on average for one month. In the event of liquidity bottlenecks, banks can thus reduce their minimum reserves to zero until shortly before the end of the month, in the certainty that the ECB will then provide sufficient liquidity to meet their reserve requirements. In the case of the Fed (2019c), the permanent open market operations correspond to the ECB’s main refinancing operations. The aim of open market operations is to manage the Federal Fund Rate, the money market interest rate in the US. Temporary open market operations have the purpose of addressing liquidity needs that are deemed to be transitory in nature. Similar to the ECB’s standing facility, the Fed introduced the Primary Credit programme as a discount window in 2003.6 The interest rate for this quantitatively unlimited refinancing is slightly above the interest rate for open market operations. The Fed also requires banks to hold central bank money as a minimum reserve. In the US only for ondemand deposits must minimum reserves be held, and there are a number of exemptions and exceptions. Minimum reserves have to be kept without interest. But it must be taken into account that the banks receive part of the profits of the regional Federal Reserve Banks they own (see above). The legally anchored freedom to choose instruments seemed to be completely unproblematic when the ECB was founded, especially as this is part of the design of all central banks. But when, after the Great Financial Crisis of 2007/08, the ECB switched to unconventional monetary policy and used new instruments in this context, a heated discussion broke out, sparked above all by Germany, as to whether the ECB had violated its mandate.

Accountability and transparency Central banks with a high degree of independence should not indulge in secret diplomacy. On the contrary, these central banks, in particular, should maintain a high degree of transparency. This is also the case for the ECB to a certain extent. The Governing Council of the ECB must submit an annual report on its activities to the European Parliament, the ECo, ECOFIN and the European Council. After the presentation of the report, the vice-president of the ECB is available for discussion via the European Parliament. Furthermore, the president of the ECB appears quarterly at the Committee on Economic and Monetary Affairs of the European Parliament to answer questions. Close contacts also exist between ECOFIN and the

Governing Council of the ECB. The president of ECOFIN and a member of the ECo may attend meetings of the Governing Council of the ECB, and members of the Governing Council of the ECB may attend meetings of ECOFIN where monetary policy issues are discussed. Another aspect of transparency is the disclosure of monetary policy to the public. The ECB fulfils this obligation by holding press conferences every six weeks. It also publishes annual, quarterly and six-weekly economic reports which show the monetary policy stance. It also regularly publishes its growth and inflation forecasts as background information to the public. This policy is essentially the same as that of the Fed or other central banks in developed countries. However, there is a remarkable difference between the ECB and the Fed. The ECB is much more closed than the Fed when it comes to internal opinion-forming. Thus the Fed publishes the individual voting behaviour of the members of the FOMC after a few weeks. Minutes of the meetings with summaries of the different positions are published after a few days and the exact transcript of the meetings five years later. In contrast, the ECB does not disclose how the members in the Governing Council voted. Instead, the press releases give the impression that the decisions were taken by consensus and unanimously. This impression is reinforced by the fact that the members of the Governing Council have to represent the majority position externally. This means that no transcripts of Governing Council meetings are published. This secrecy is justified by the argument that the national members of the Governing Council should not be exposed to pressure from national interest groups and governments. This argument is not convincing, however. Given the size of the ECB administrative apparatus, national governments and large lobby groups, in particular, should have anyway the opportunity to obtain information about debates within the Governing Council of the ECB quickly and will try to influence members of the Governing Council. The lacking openness of the ECB creates the danger of asymmetric information. In addition, transparency of decisions is more important than the danger of influencing members of the Governing Council. Debates within the Governing Council should be made available so that the public can understand monetary policy better. In this respect, the ECB would be well advised to take the Fed as a role model.

Legal foundations of independence In the United States, Congress can change the legal basis for the Fed’s work. The independence of the Deutsche Bundesbank was also laid down in law by the German nation state. In contrast, the treaties concerning the ESCB are based on international law and can

only be changed unanimously within the EU. In practice, this does not currently play a large role, but may become a significant issue in the future.

Summary If all dimensions of independence are taken together, the ECB is the most independent central bank in the world (Bofinger 2001). On the one hand, this is because of the regulations in place, such as the ECB’s right to determine price level stability or the limited transparency of what happens in its Governing Council. On the other hand, it is also the result of the ECB’s position as a supranational institution lacking an equivalent partner in the form of a federal government in the eurozone. In its legal framework the Fed is as independent as the ECB. But since its creation the Fed has had an intensive relationship with the US Treasury. Depending on the overall political and economic situation and personal relations at play, the Fed has actually demonstrated different degrees of independence (Slivinski 2009). After neoliberal thinking, an independent central bank is a desirable goal. The construction of the ECB as a supranational institution hovering above the nation states appears to be an extremely positive thing. Olaf Sievert, a renowned German economist and long-term member of the German Council of Economic Advisors, wrote in a contribution entitled “Money, which cannot be self-made” that it is important in a monetary union that member states have to repay their debt in money, which they cannot produce themselves (Sievert 1992: 18). For him, the construction of the ECB and EMU, therefore, represented good neoliberal institution building. In a newspaper article, he later stated that the state had to tie itself down. The most important shackles are the renunciation of national sovereignty in the field of monetary policy and a constitutional restriction on national debt (Sievert et al. 2010; see also Thomasberger 2012). Sievert stands for a whole group of ordoliberal economists who were influential in Germany after the Second World War. Their basic idea was that supranational institutions should be created to restrict democratic demands, such as those for redistribution, and to prevent unilateral national policies, which were considered to be dangerous. European integration without state building was regarded as a development in the right direction as it would imply technocratic rules, which were shielded against democratic national demands (Slobodian 2018).7 In this tradition the high degree of ECB independence and its “political abstinence” led to the expectation that monetary policy would not play a key political role in the political development of the EMU and EU. However, after the outbreak of the Great Financial Crisis in 2007/08 reality has assigned it a different role.

5 PRECONDITIONS FOR A STABLE MONETARY UNION

With the introduction of the euro as the common currency in 1999, the EMU member states took a major step towards integration whose economic and political significance could only be underestimated. From an economic point of view, a domestic currency is an essential component of a nation state, whether that is politically desired or not. Economically members of a currency union become regions within the common currency area. They renounce the possibility of exchange rate adjustments and an independent monetary policy. In a currency area, the common central bank holds the monopoly over issuing money. It dictates the shortterm interest rate in the whole currency area, refinances commercial banks and acts as lender of last resort. Monetary policy not only influences the inflation rate in a currency area, but it also deeply influences its economic development including long-term growth and employment. If a country with an independent currency joins a monetary union it changes one of the key fundamentals of its economy. In our opinion, money and monetary policy are neutral neither in the short nor in the long term. This is in line with Keynes’ paper, “A Monetary Production Economy”: The theory which I desiderate would deal … with an economy in which money plays a part of its own and affects motives and decisions and is, in short, one of the operative factors in the situation, so that the course of events cannot be predicted, either in the long period or in the short, without a knowledge of the behaviour of money between the first state and the last. And it is this which we ought to mean when we speak of a monetary economy. (Keynes 1933: 408)

This view corresponds to the fact that the world economy is divided into different currency areas, which in turn are subdivided into different regions. Different currency areas in conjunction with the specific monetary and other macroeconomic policies followed lead to different economic developments. This does not mean that money and monetary policy alone determine economic development. But it means that they have a substantial influence on short-term and long-term developments. The type of monetary union can thus promote growth and employment, but it can also trigger the opposite. In this section, we analyse the ten basic preconditions for a functioning monetary union and compare these conditions with the situation at the time when the euro was created. When these preconditions are not fulfilled, negative effects must be expected. 1.

A monetary union must guarantee the basic precondition of a monetary production

economy to promote prosperity – the stability of money as defined as a low and relatively stable inflation rate. High inflation rates and deflationary developments lead to the danger of cumulative processes and destroy the coherence of a monetary production economy. Taking these in turn, a central bank that wants to avoid the negative effects of a currency with a poor reputation must have the power to fight against inflationary processes with restrictive monetary policy. As medium-term intolerable inflationary processes are based on excessive increases of nominal unit labour costs, the ideal way to establish a stable, low inflation rate is a functional increase of nominal unit labour costs (see point 7) at the level of the desired inflation target (Keynes 1930; Herr 2009; Heine & Herr 2013: 422 ff.). If the wage anchor breaks and inflation climbs too high a central bank, which wants to prevent the erosion of its monetary system, is forced to use its restrictive power even if growth slows down and unemployment increases. This does not imply that a central bank should not allow a certain flexibility of the inflation rate and should permit external price shocks – such as increases in the price of oil or taxes – to affect the inflation rate in the short term. When the euro was established there was no danger that the ECB would not be able to defend a low inflation rate. A central bank also has to fight against deflationary processes. Irving Fisher (1933) convincingly showed that deflations greatly increase the real debt burden, lead to financial crises and a sharp fall in investment and consumption demand.1 As the power of monetary policy is asymmetric a central bank can fail to prevent deflation, as for example happened in Japan’s recent economic history (Herr 2015). Also, the ECB has not been able always to increase the inflation rate to its target rate. The Great Depression in the 1930s is an example of a cumulative process of falling nominal wages, falling prices, further distortions in the financial system and exploding unemployment. The crucial anchor against deflation is to prevent nominal decreases of unit labour costs. This means labour market institutions, such as minimum wages and wage bargaining processes which prevent falling or too low nominal wage increases, have to be strengthened. The danger of deflation triggered by too low nominal wage increases or even falling nominal wages shows that the power of central banks is limited and it does not act in a vacuum. Monetary policy has to be embedded in stabilizing institutions and policies by other economic agents. Joint institutions in the EMU to prevent deflationary developments almost do not exist and are insufficient (see point 6). 2. The relationship between public budget deficits and monetary policy has to be resolved in a way that stabilizes a monetary union. The unlimited financing of escalating budget deficits by the printing press of the central bank can lead to high inflation, even hyperinflation. The typical interaction between high budget deficits, money creation and

escalating inflation is as follows: the financing of budget deficits by the central bank increases monetary wealth in the domestic currency if a sterilization of money creation is not possible or wanted (Robinson 1938). If the private sector does not accept holding increasing monetary wealth in the domestic currency and exchanges most of it into foreign currency, depreciation follows leading to a depreciation-inflation spiral. The erosion of confidence in the domestic currency leads to cumulative capital flight and finally to hyperinflation. Historical examples are the German hyperinflation in 1923, but also the episodes in the early 1990s in Russia and in Zimbabwe in 2008/09. In the present economic and political constellation in the EMU, it is very unlikely that budget financing by the central bank leads to high inflation. Governments have no power to force the ECB to finance public budgets. The possibility of inflationary processes triggered by budget financing by central banks should not disguise the fact that in other constellations the central bank has to take over the function as lender of last resort for public households (De Grauwe 2011). To make rules that a central bank may not under any circumstances help public households to avoid the extreme effects of hyperinflation is misled. Central banks and monetary policy have to act in a discretionary way in accordance with each historical constellation (see point 5). 3. In crisis periods public deficits and, therefore, public debt increase endogenously as expenditure (e.g., for social and labour market policy) increases and at the same time tax revenues (via income tax or value-added tax) decrease. This can apply to a crisis-ridden region as well as to an entire currency area. Functional fiscal policy has to accept endogenously developed budget deficits and the automatic stabilizers. For deeper crises, an active countercyclical fiscal policy is also needed. Functional fiscal policy includes reducing budget deficits in upswing phases. Over the business cycle public budget deficits should be at a level in which government debt in relation to GDP does not permanently increase. An optimal debt-to-GDP ratio cannot be theoretically determined. A very low debt-to-GDP ratio is of no value as such, since government is not providing a safe asset for wealth holding in the private sector; similarly, a very high public-debtto-GDP ratio can trigger negative distribution effects and can lead to destabilizing budget developments in phases of high interest rates. A monetary union must prevent member countries from pursuing irresponsible fiscal policies. The external effects of a member’s fiscal policy for other members of the monetary union are so significant that certain fiscal policy rules for member states are necessary. An example of irresponsible fiscal policy is the pursuit of austerity policies at the expense of others during periods of crisis or by generating additional demand through budget deficits during a boom. Anti-cyclical fiscal policy is normally carried out by the federal government,

which has a strong finance and economics ministry, sufficiently high public expenditures and public revenues and the right to have a budget deficit and issue bonds. Of course, even a strong fiscal centre can pursue the wrong fiscal policy. However, the probability for such a scenario is much lower than when the fiscal centre is weak or has to leave active fiscal policy completely to the voluntary cooperation of the member states. The EMU-fiscal centre, the ECo, has a very small budget, no right to take credit and no fiscal policy functions at all. A central EMU fiscal policy simply does not exist. 4. The ECB, which became responsible for monetary policy with the introduction of the euro, can only grant uniform refinancing conditions. But the member states of the EMU do not have to have the same economic conditions. Germany, for example, was confronted with a persistent phase of low growth after the introduction of the euro and was regarded as the “sick man of Europe” (Sinn 2003), while growth rates in Spain, Ireland and Greece were high. In the latter countries dangerous real estate bubbles developed, whereas in Germany real estate prices were stable. After the Great Financial Crisis in 2008/09 the situation changed completely. Now real GDP growth in Germany was higher than for example in Spain and Greece and a real estate bubble developed in Germany (see Chapters 7 and 8). Before the Great Financial Crisis, for example, interest rates for Germany were too high and after the Great Financial Crisis too low, for Spain and Greece the inverse was the case. A monetary union has to have institutions and policies to combat these different developments (Simonazzi et al. 2019). A strong federal budget, including active fiscal policy, is needed to support weaker regions, among other things. If different regional developments solidify, regional and structural programmes and public transfers are necessary to promote less well-developed regions. However, in the EMU the coordination of fiscal policy by the individual member states works poorly or not at all. European structural programmes are not sufficient in financial terms to effectively promote the economically weaker countries. And there are no automatic inter-regional transfer mechanisms, such as an EMU-wide unemployment insurance or pension system. 5. All historical experience shows that monetary economies are repeatedly affected by financial crises, especially in the present historical situation of huge international capital flows and deregulated domestic financial markets. To fight against such crises and prevent their escalation into systemic, disastrous crises central banks must provide commercial banks and other institutions, under certain conditions, with unlimited liquidity. They must therefore act comprehensively as lenders of last resort for the financial system (Bagehot 1873). There should also be an institution and mechanisms in place for winding up banks or other financial institutions that should or could not be

saved during financial crises. When the EMU was established no precautionary measures were established for what should happen in the case of a financial crisis affecting the whole EMU. It might be expected that the ECB would take over a role of lender of last resort for the banking system and even other financial institutions in liquidity needs. However, what should happen with insolvent financial institutions, if they operated in several member states of the EMU? What about deposit insurance in the EMU, can this be left to schemes of member governments? 6. After the deregulation of international capital flows in the 1970s, debt crises have become frequent in countries that have borrowed abroad in foreign currency. Such debt crises usually happen after a period of high capital inflows and current account deficits during a boom phase, which suddenly comes to an end and is followed by a bust phase with capital outflows due to negative expectations. Such debt crises can hit public budgets, the private sector and especially the financial sector of a country very hard. Financial crises in the private sector usually burden the public sector, which has for systemic or political reasons, offered bailouts to over-indebted private financial institutions or companies. Countries in such situations suffer usually from very costly crises, as the central bank cannot take over the function of lender of last resort as the economic units are indebted in a foreign currency and a central bank cannot create foreign currency. Countries affected by such crises have to ask for help from foreign countries or international institutions like the IMF. As creditors in most cases enforce austerity policy or even policies to privatize state-owned companies or change the social security systems these countries lose large parts of their sovereignty. For members of a normal monetary union such debt crises do not happen as long as debt is denominated in domestic currency. This is because over-indebted governments at the state or regional level will be bailed out by the federal government. If the federal government has refinancing problems the central bank will help in its role as lender of last resort for the central state – via interventions in secondary markets or refinancing banks, which give credits to the government. The eurozone is fundamentally different from this. According to the Maastricht Treaty, no EMU member state may be obliged to provide financial assistance to another member state. The EU lacks a federal government with sufficient financial power to help member states. Behind the no-bailout clause was the hope that financial markets would sanction governments in member countries whose public debt was too high. The hope was that governments, knowing that they would not be bailed out, would never take on too much debt and become over-indebted. The no-bailout clause shows how naïve the founders of the EMU were. Financial markets with their waves of euphoria and pessimism are not in a position to

anticipate rationally the financial situation of public budgets. This has been empirically confirmed during external financial crisis in developing countries time and again. What happens when a government in a member state of a monetary union misbehaves and becomes over-indebted? Or what happens when a government has or wants to bailout the financial system in its own country when it is in trouble? Under no circumstances is it a realistic option in a monetary union to let a government in a member state collapse. The social, political and economic effects for the country in crisis and the whole monetary union would be too big to contemplate a collapse. The problem was that at the time of the EMU’s foundation, member governments of the EMU or EMU institutions had not anticipated and had no idea how to deal with governments in crisis. The simple solution for this problem in normal monetary unions is for the central bank to assume the function of lender of last resort. This implies that the central bank guarantees the liquidity of governments including financing budget deficits. The consequence of a lack of a lender of last resort for public households was that within the EMU boom-bust cycles problems could develop comparable to those of developing countries in bust phases. Their central banks could not help governments in crisis as central banks could not create the (foreign) money needed. The countries had to search for external help and as a consequence follow policies in the interest of their creditors (see Chapter 9). 7. We have mentioned above that there is a close link between the development of nominal unit labour costs and price levels. In a closed economy it can be shown that the increase in unit labour costs leads to a proportional increase in the price level. Empirically, this correlation is surprisingly stable, despite a number of other factors that also affect the price level, such as exchange rates, taxes or commodity prices (Herr 2009). Consequently, a functional development of the nominal wage level, i.e. one that realizes the target inflation rate, becomes important for the stability of a monetary union. The target inflation rate is achieved when the level of nominal wages rises in line with the trend in productivity growth plus the inflation rate desired in the medium term. The trend or over-cyclical productivity growth in the economy as a whole is important here, as the statistically measured productivity growth depends on the business cycle. This is because statistically measured productivity decreases during a downturn and increases during an upswing, as employment can only be adjusted to changes in the production volume after a time lag. If nominal wage increases follow this rule then the level of real wages rises in line with medium-term productivity developments and wage cost increases are in line with the target inflation rate. Such a rule for wage development also prevents deflationary developments. There are no mechanisms in the eurozone that could meet the requirements of a functional

wage development across the whole monetary union and in its member states. Normal monetary unions have a common internal labour market. In the EMU this exists only to a very limited extent. The lack of a common labour market creates two types of problems. First, there is no EMU-wide mechanism for effecting a functional nominal wage development that follows trend productivity plus the target inflation rate. Secondly, even when on average nominal wage increases are functional, a situation can develop in which regional wage developments are uncoordinated and become too high in some regions and too low in others. If this happens, regional distortions follow. EMU-wide wage negotiations do not exist. There is no EMU-wide coordinated minimum wage. In normal monetary unions, even in those with very weak labour market institutions, a number of mechanisms exists which foster coordination of wage development. Statutory minimum wages play an important role in this. Also, certain sectors can take over the role of wage leaders and signal wage developments in a specific wage round. Wage development in the public sector is also usually more or less the same in the whole monetary union. Furthermore, low barriers to mobility (such as language or culture) contribute to relatively uniform wage developments in a monetary union. Mobility is also promoted by a common social security system in the monetary union; a common pension system for example avoids complicated recognition problems when a worker moves from one region in a monetary union to another. All these institutions and mechanisms do not exist in the EMU. Trade unions have not experienced any changes in their organizational structure since the establishment of the EMU. They are still almost exclusively national associations with specific forms of organization and wage formation mechanisms and, if at all, minimal solidarity among themselves. The same is the case for employers’ associations. Not surprisingly, member countries of the EMU have had very different trajectories for unit labour costs with distorting effects (see Figures 7.5 and 7.6). 8. Current account imbalances between regions in currency areas arise primarily from different wage cost developments and different growth rates. In monetary unions these imbalances can no longer be tackled by exchange rate adjustments. Several policies are needed to prevent current account imbalances leading to destabilizing processes in a monetary union. Unit labour costs should develop in a way that they do not become a factor for current account imbalances. In a monetary union, price competitiveness among regions is not affected by wage developments in all regions, if regional nominal wage increases are in line with the regional trend of productivity development plus the target inflation rate of the monetary union. For current account imbalances growth differences between regions are usually even more important. Fiscal policy and regional industrial policy to stimulate growth in poorly growing

regions come into play here. If high growth in some regions is triggered by real estate bubbles that will ultimately burst, then it is necessary to dampen growth in the corresponding region by combating the asset bubble through regionally adjusted measures. Certain imbalances of current accounts within a monetary union usually do not lead to crises. Within monetary unions regional capital flows normally remain relatively stable. In the EMU this is not the case. Capital flight from crisis regions to stable regions within the EMU is possible and has happened. Because the financial system is still regionally centred, there is no EMU-wide deposit insurance for the banking system and yet regional deposit insurance is insufficient to cover all regional deposits in cases of bankruptcies. .

9. A monetary union requires common tax and welfare elements. In a monetary union the tax system for the most important taxes should be largely harmonized. It is therefore dysfunctional for a monetary union if income tax rates differ significantly between the member states, if companies are taxed very differently or if tax havens for the rich and large companies exist within the member states of a monetary union. Such a framework leads to downward tax competition and low tax burdens for rich households and big companies. A monetary union should also support at least elements of a common social welfare system. Countries that are in a deep crisis and whose social systems are therefore under pressure should not be left alone. For example, a common unemployment insurance system leads to a certain automatic stabilization of crisis regions through social transfers. In the EMU there is no common tax policy and low-tax countries, such as Ireland, Luxembourg or the Netherlands are encouraging tax dumping. The whole social dimension of integration has not only been neglected, but entirely omitted from European integration. 10. A monetary union should be supported by the majority of the population. To a certain extent there should be a common identity that allows solidarity within the monetary union. In the Eurobarometer the ECo asks the European population about its support for the EU and the euro. In the 2018 survey 75 per cent (2004: 70 per cent) of the population in the eurozone were in favour of the euro, 20 per cent were (2004: 25 per cent) against it.2 In answer to the question of whether they felt they were European citizens, in 2018, 71 per cent answered “yes”, 21 per cent felt “no”. There were big differences among countries. For example in Germany 86 per cent were positive and 13 per cent negative, in Spain 83 per cent replied “yes” and 16 per cent “no”, in France it was 62 per cent “yes” and 37 per cent “no” and in Italy 59 per cent and 40 per cent (ECo 2018). The political legitimacy of the euro area is, at least in a number of member countries, unsatisfactory. This can be attributed to the fact that in many countries of the EMU and the EU at large populations do not want a European state. In spite of the

economic pressure to do so, governments of EMU member states are reluctant to transfer power to supranational institutions. Also, apart from rather unimportant exceptions, there is no broader European discourse in the form of daily newspapers or other mass media. Ultimately, political debates in the EMU primarily take place at national level. In the European Parliament there are no European parties, instead national parties with a more or less similar political agenda form groups within the parliament. The EMU has been primarily a project of internationally active companies, represented by business associations and representatives of the financial system, and international political elites. The EMU was attractive as it offered a bigger market, the exploitation of economies of scale, cost reductions because of more efficient production and lower costs to exchange currencies, cutbacks of rigidities in national markets, higher competitiveness vis-à-vis the United States and other economic blocs, etc. The social dimension of monetary union was ignored completely. This absence of a European identity also explains in part why the eurozone countries showed so little solidarity during the crisis after 2008 and why each country pursued its own interests, even though it disadvantaged the development of the monetary union as a whole.

Summary From 1999 until the outbreak of the financial market crisis in 2007/08, the dysfunctional institutional structure of the EMU was largely concealed by the moderately positive economic development it brought about. But with the crisis, the weaknesses of the EMU were exposed and explain the subsequent poor economic development of the EMU (see the chapters below). Some of the weaknesses in the construction of the EMU could have been anticipated from the lively debate over optimal currency areas (Priewe 2008). Robert Mundell (1961), for example, showed that in spite of advantages (reduction of transaction costs and uncertainties in exchange rate movements) monetary unions could have severe problems with asymmetric shocks. If, within a monetary union, only one region is affected by a crisis, such as a decline in demand for an important export good for the region, then certain conditions should be met so that the monetary union can overcome the crisis in this region. First, wages should develop in such a way that the crisis region becomes more competitive. Secondly, high labour mobility, in our example emigration from the crisis region, should encourage the adjustment process. Thirdly, fiscal transfers to the region in crisis, including a regional industrial policy, should help the region to overcome the problems. If these conditions are not met, then, Mundell argued, it would be economically more advantageous for the crisis region to have its own currency in order to be able to put exchange rate and monetary policy at the service of combating the crisis.

Ronald McKinnon (1963) added to Mundell’s argument that a monetary union is particularly favourable for large currency areas with relatively little international integration, while it is less efficient for small and very open economies. If in a small and open economy depreciations are used to increase price competitiveness this may fail. Depreciations increase the domestic price level because of the openness of the economy and reduce the intended real depreciation. Moreover, if depreciations trigger a price-wage spiral, nominal devaluation can completely fail to achieve a real depreciation. According to Peter Kenen (1969), the stability of a monetary union increases with the diversification of its production structure, as a diversified economy is better protected against asymmetric shocks. He also stressed the need for relatively homogeneous preferences and values of member countries of a monetary union, a common vision of future development and a certain degree of solidarity between member countries as prerequisites for a stable monetary union. All these arguments are useful to judge the economic advantages and disadvantages and stability of a monetary union. It also provides some important indications as to the direction institutional reforms should have taken before or at the latest immediately after the EMU was created. To judge whether this debate discusses the problems of the EMU sufficiently it has to be checked whether asymmetric shocks are central to the problems of the EMU. There have been asymmetric shocks in the EMU and they can also be expected in the future. However, asymmetric shocks are not the only problem in the EMU. At least as important are symmetric shocks, i.e. shocks affecting the entire currency area. This problem has not been discussed in sufficient depth in the debate about optimal currency areas. Obviously, no monetary union could be imagined that could not deal adequately with symmetric shocks, such as a general economic slowdown or a financial market crisis in all member countries. But when the EMU was created it lacked institutions that could adequately combat them. The EMU was thus poorly equipped to deal with both asymmetric and symmetric shocks. Both shortcomings are attributable to the fact that the EMU is not part of a nation state and does not want to become one. In the following chapters the development of the EMU is analysed in detail. It will become clear that the EMU, under the pressure of crises, was forced to remedy some of the institutional shortcomings, although most remain.

6 THE FAILURE OF THE TWO-PILLAR STRATEGY OF THE ECB AND THE REVIVAL OF WICKSELL

In this chapter we examine the evolution of the ECB’s monetary policy and its theoretical approach in the first phase of EMU. First we set out the character and role of money in the Keynesian paradigm. Then we turn to the two-pillar strategy of the ECB, which combined neoclassical and Keynesian elements of monetary policy. Finally, we examine the Wicksellian approach to money and monetary policy, which became dominant after the failure of the two-pillar strategy.

Money in the Keynesian tradition Money in a monetary production economy (Keynes 1933) plays a central role for stability and dynamics of capitalist systems. Money has three basic functions: as a unit of account, as a means of payment, and as a store of wealth. Money as a unit of account is the most basic function of money and cannot be substituted without changing the monetary system. An example is the change from the D-Mark to the euro in 1999. Money as a unit of account is needed to express the value of goods and for calculations in balance sheets, etc. More importantly, money is a unit of account in credit contracts. In this function it becomes highly desirable that the unit of account measured in real purchasing power is stable, which requires a relatively stable and low inflation rate. In a situation of high inflation rates creditors can at least theoretically defend a given real interest rate (nominal interest rate minus inflation rate) when the nominal interest rate is adjusted to the inflation rate. But uncertainty in such a situation and the danger of the further erosion of the monetary system is high. During deflation the real debt burden increases (Fisher 1933). Money as means of payment is transferred from one economic agent to another to buy goods, to pay out or pay back credits, and to fulfil all kinds of obligations, such as taxes. This function of money implies that money has to be kept as a store of wealth. There are several motivations to keep money. First, money is kept to carry out daily transactions. Second, if the cash flows of private households or firms are irregular, money is kept for precautionary purposes. Third, speculators may see advantages to keep cash. Finally and most importantly, money is held as the embodiment of wealth as such. In this function it

provides for its holder protection against the general insecurities of life including the instabilities that economic agents are exposed to in a capitalist economy. And it gives the holder power in many different dimensions. Karl Marx (1867: 85f.) understood this character of money very well. For him money was “an absolutely social form of wealth, ever ready for use … But money itself is … an external object, capable of becoming the private property of any individual. Thus social power becomes the private power of private persons.” It was Keynes who, like no other economist, stressed the rationality to hold money as a safeguard against uncertainty: “Because, partly on reasonable and partly on instinctive grounds, our desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. … The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude” (Keynes 1937: 316). Money as a store of wealth can be substituted in many different ways. A very close substitute for hoarding cash is to keep demand deposits in banks – if banks are considered to be safe. All kinds of monetary assets can be used as stores of wealth. There is a continuum from money as the most liquid and safest form of monetary wealth to increasingly less liquid forms. Liquidity has in different financial systems different meanings. It is obvious that only money with a high “asset protecting quality”, as Hajo Riese (1986: 156, 237) called it, can serve the needs of economic agents. Inflation and deflation undermine the coherence of a monetary production economy. From the perspective of the monetary Keynesian paradigm, a stable low inflation rate is a key condition for prosperous economic development (see also Chapter 5). Low inflation does not automatically trigger a positive economic development, but inflationary and deflationary developments destroy the basis of capitalist economies. There is a hierarchy of currencies. Of the 160 currencies in the world only a small number, mainly the US dollar and the euro, can assume national and international functions. A group of probably 20 currencies takes over all national functions, but no international functions. These are mainly the currencies of developed nations. In most developing countries foreign currencies, again mainly US dollar and euro, penetrate domestic financial systems and take on national functions in these countries. Monetary sovereignty is high for currencies at the top of the hierarchy and decreases sharply for currencies at the bottom.1 For monetary policy the role of money in a monetary production economy has two major consequences. First, the state of confidence, expressing expectations and the level of uncertainty, changes with historical developments. This effect leads to a potentially unstable demand for money or better liquidity (Keynes 1936, 1937). This makes any monetary policy that tries to control a monetary aggregate difficult and dysfunctional. Traditional monetary policy involves interest rate policy with the refinancing rate of central banks as the main policy instruments. Money in such an approach becomes endogenous (Heine & Herr 2013).

Second, the power of monetary policy is asymmetric. The logic of a monetary production economy makes this clear. Keynes, who followed Marx on this point, stressed that the nucleus of a capitalist economy can be expressed in the general formula of capital (Evans et al. 2007). To organize production, money (M) is advanced to purchase commodities and labour (C), these are used to create income and, on the other side of the coin, to produce new commodities with a higher value (C’). These are sold to earn more money back than advanced (M’). As the general formula of capital M – C … C’ – M’ is embedded in credit relations we get M – M – C … C’ – M’ – M’, a firm (or an entrepreneur) that is financed mainly by banks but also by private-wealth owners, invests the money in productive activities and after selling the product repays the credit.2 Economic dynamics depend on credit expansion. There is no better economist than Joseph Schumpeter (1911: 107) to explain this: “Credit is essentially the creation of purchasing power for the purpose of transferring it to the entrepreneur, but not simply the transfer of existing purchasing power. … Granting credit in this sense operates as an order on the economic system to accommodate itself to the purposes of the entrepreneur.” According to Schumpeter, the banking system creates finance ad hoc or out of nothing (Deutsche Bundesbank 2017a). Banks can then use the refinancing of central banks to give credits to entrepreneurs who carry out production and income creation. In most historical constellations the macroeconomic budget constraint is not given by the physical stock of labour and capital goods in an economy. It is given by a monetary budget constraint, by the amount of money invested in productive processes (Riese 1986: 65f.). The entrepreneur organizes production processes and invests when the expected rate of return is higher than the interest rate he or she has to pay for the money borrowed and invested.3 Investment, production and employment are low when expectations are bad and/or monetary policy pushes the interest rate above the expected rate of return. Investment, production and employment are also low even when refinancing rates are zero, if expectations of banks and wealth owners are poor, credit rationing high and/or lending rates for firms remain high in spite of low refinancing rates of banks. As this shows, the central bank is one player among many; it has restrictive power but can be weak at stimulating the economy. It cannot control the credit volume and even the amount of central bank money in the private sector in the event that a private credit expansion does not take place. And it cannot stimulate investment, production and employment if bankers and entrepreneurs have negative expectations. Even deflation cannot be prevented when wage costs decrease.

The two-pillar strategy of the ECB Now that the institutional framework of the ECB’s monetary policy has been presented, we

will scrutinize the policy itself, implementing the Keynesian understanding of money. Until the Great Recession that began in 2009, resulting from the Great Financial Crisis 2007/08, two phases can be distinguished. The first was characterized by the so-called two-pillar strategy of monetary policy, which failed. The second deals with the instabilities in the EMU that built up before the outbreak of the Great Recession and the inability of the ECB to combat them successfully. In this chapter the two-pillar strategy is discussed. The ECB laid down its stability-oriented monetary policy strategy in its first Monthly Bulletin in January 1999 (ECB 1999). The all-dominant goal of the ECB is price stability defined in this first Bulletin: “Price stability shall be defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2 per cent” (ECB 1999: 46). Furthermore, it was stated that deflationary developments should be avoided. The ECB thus set itself an inflation target of between zero and 2 per cent. The ECB placed itself in line with the monetary policy trends of other central banks, which also generally set an inflation rate target to be achieved in the medium term. Nevertheless, the ECB’s monetary policy strategy cannot be interpreted as the usual inflation targeting, which was introduced by many central banks in the 1990s. For example, in 1990 New Zealand and in 1991 both Canada and the UK adopted an inflation targeting strategy. In these cases, the central bank or, as in the UK, the government sets the inflation target. In these central banks the forecast inflation rate is compared with the inflation target. If the forecast inflation rate is higher than the target, the interest rate is raised. If the converse is true, the interest rate is lowered. The development of monetary aggregates does not play any role in this monetary policy strategy. As distinguished from the normal inflation targeting strategy the ECB relied on a two-pillar strategy. The first and more important pillar was rulebased and followed the control of a monetary aggregate in the tradition of Milton Friedman (Friedman 1968). The second pillar, on the other hand, was based on a large number of economic indicators and was discretionary. With regard to the first pillar, the ECB writes: “To signal the prominent role it has assigned to money, the Governing Council has announced a quantitative reference value for monetary growth as one pillar of the overall stability oriented strategy” (ECB 1999: 47). The theoretical background for this is provided by the quantity theory of money. It asserts that a stable relationship exists between the rate of price change and the growth of a monetary aggregate. A monetary aggregate, interpreted as money supply, serves monetary policy as an intermediate goal that should be controlled with the refinancing rate of the central bank. Milton Friedman and monetarism in general wanted to prevent discretionary monetary policy by means of a rule-based system. According to the argument, the pursuit of a money supply rule would guarantee a long-term and rule-bound monetary policy and thus reduce uncertainties (Friedman 1968). The ECB selected M3 as the monetary aggregate to be controlled. M3 is an aggregate of

liquidity and defined in an arbitrary way.4 When calculating the desired monetary growth of M3, the ECB took three variables into account. First, it assumed a medium-term real GDP growth of 2–2.5 per cent. Second, it estimated that the velocity of money in circulation would decrease by 0.5–1 per cent. This implies that the private sector would increase its desired liquidity holding in relation to GDP. Third, the inflation target was, as explained, below 2 per cent. As a consequence “the Governing Council decided to set its reference value for M3 growth at 4½ per cent per annum” (ECB 1999: 49). The less important second pillar of monetary policy consists of a broad range of economic indicators used to map economic developments that may not be covered by M3. This second pillar also opened up the possibility of not having to slavishly adhere to the reference value of money supply growth at all times: “Therefore, in parallel with the analysis of monetary growth in relation to the reference value, a broadly based assessment of the outlook for price developments and the risks to price stability in the euro area will play a major role in the Euro system’s strategy. This assessment will be made using a wide range of economic indicators” (ECB 1999: 49). These indicators include wage developments, exchange rates, bond prices, the yield curve, fiscal policy indicators, price and cost indices as well as industry and consumer surveys. Inflation forecasts by international organizations and research institutes would also be taken into account to assess the EMU’s economic situation (ECB 1999). This two-pillar strategy implied a mixture of different monetary policy approaches and was anything but clear. In this respect, it made no contribution to the transparency of monetary policy in the EMU (Bofinger 2001: 300f.). For it could not be ruled out that the two pillars of monetary policy would give rise to different conclusions. Thus, the first pillar could suggest a restrictive and the second an expansionary monetary policy (or vice versa). In fact, this dilemma occurred shortly after the ECB started its operation (see below). The two-pillar strategy can be interpreted as a modified continuation of the Deutsche Bundesbank’s monetary policy. After the collapse of the Bretton Woods system in 1974, the Bundesbank switched to monetary targeting. It tested various monetary aggregates and defined a corridor for each year within which growth of the monetary aggregate was to move. In the long phase from 1974 to 1998, however, it was only able to achieve its money supply target in about half of the cases. It accepted divergences from its planned monetary supply growth without a lot of fuss. In fact, for the Bundesbank monetary targeting was not a strict monetary policy strategy akin to Friedman’s, it was rather a signal to the private sector and especially to the collective bargaining parties, in order to make it unmistakably clear that it would unconditionally combat wage agreements with an inflationary effect (Bofinger 2001). The ECB quickly experienced shipwreck with its two-pillar strategy. Figure 6.1 shows the development of the inflation rate and the M3 aggregate in the EMU. The inflation rate was below 2 per cent in 1999, but then between 2000 and 2007, the beginning of the financial

market crisis in the United States, it rose between 2.1 per cent and 2.4 per cent. M3-growth reached 6 per cent in 1999 and 2000; then fell to the reference value of 4.5 per cent, before rising by 8 per cent annually for several years. After a short period of somewhat lower growth rates, M3 then rose massively with growth rates of over 10 per cent in 2007 and 2008. With the best will in the world, no short-term or even medium-term stable relationship could be identified between the development of M3 and the inflation rate.

Figure 6.1 Annual growth rates of M3, consumer price index and real GDP in the EMU, 1999–2019 Source: ECB Statistical Data Warehouse (2020).

Figure 6.2 shows the three interest rates set by the ECB, the main refinancing rate and the interest rates on the deposit facility and marginal lending facility. Also shown is the shortterm money market interest rate in the EMU, the EONIA (Euro Overnight Index Average), which is the rate that financial institutions charge for short-term loans to other financial institutions (see Chapter 4). In the period from 1999 until 2007 which we analyse here, the EONIA is close to the main refinancing rate. This reflects the fact that in the first phase of the EMU, the ECB provided the commercial banks with sufficient liquidity via the main refinancing operation. Although the discount window always remained open, the banks did not have to make much use of it. The EONIA has never been close to the marginal lending facility for an extended period of time. The interest rates for the deposit facility and marginal lending facility, which form the theoretical limits for the EONIA, show no abnormalities in the first phase of the EMU.

Figure 6.2 Refinancing rates of the ECB and money market interest rate, 1999–2019 Source: ECB Statistical Data Warehouse (2020).

It is worth noting that on 28 June 2000 the ECB switched from fixed-rate tenders to variable-rate tenders in its main financing operation. In fixed-rate tenders, the central bank specifies the refinancing interest rate and the banks inform the central bank of the refinancing volume they are interested in. If the amount of central bank money desired by the commercial banks exceeds the amount that the ECB would like to allocate, the commercial banks will be serviced pro rata. In the case of variable tenders, the central bank sets the minimum refinancing interest rate and the individual banks then indicate at which interest rate, which must be above the minimum interest rate, they request refinancing. The banks with the highest interest rate bids are then served first, then those with the second highest, and so on, until the amount of money that the ECB has earmarked has been spent. At the Bundesbank, for example, fixed-rate tenders worked well, as the number of banks was relatively small and certain rules were observed. Under the EMU, the fixed-rate tenders did not work due to the large number of banks and the absence of common informal rules. The allotment rate for fixed-rate tenders fell to almost zero and the ECB had to change the allocation procedure (Nautz & Oechssler 2006). The main refinancing rate at the beginning of 1999 was 3 per cent. The inflation rate in 2000 rose slightly over the 2 per cent target and M3-growth was slightly over 4.5 per cent. After a small cut of the refinancing rate to 2.5 per cent in April 1999, the ECB increased its main refinancing rate step-by-step to 4.75 per cent in October 2000. GDP growth increased in the then EMU to 4 per cent. Overall the interest rate policy by the ECB followed the logic of monetary targeting. Even more important to explain increasing interest rates in the EMU in

this period were increasing interest rates in the United States and at the same time the depreciation of the euro against the US dollar (see Figure 6.3). For the ECB, the weakness of the euro immediately after its introduction must have been judged to be dangerous. It could undermine confidence in the new currency and trigger a higher inflation rate. The second pillar of the ECB monetary policy strategy at least underpinned the first pillar.

Figure 6.3 The euro–US dollar exchange rate, 1999–2020 Note: euro per US dollar, decrease means depreciation of euro. Source: Board of Governors of the Federal Reserve System (US) (2020).

In 2001 growth worldwide collapsed because the dot-com boom came to an end.5 GDP growth in the EMU fell to 2.2 per cent in 2001. The EMU remained in crisis mode with growth rates of 1 per cent in 2002 and 0.7 per cent in 2003 (OECD 2020). At the same time, however, the annual M3-growth had risen to around 8 per cent for several years. Nevertheless, the inflation rate in the EMU posed no problem. On the contrary, in Germany, the country with the largest GDP share in the EMU, the inflation rate dropped to around 1 per cent. The IMF (2003) even saw deflationary risks in Germany (and in some other countries such as Japan and Hong Kong). The ECB was caught in a dilemma: the first pillar of its monetary policy strategy called for a sharp increase in interest rates due to the sustained high money supply growth, while the second pillar suggested a sharp reduction in interest rates due to the poor economic development and the danger of deflation. In view of this dilemma, the ECB abandoned monetary targeting and lowered the main refinancing rate to 2 per cent in June 2003, before maintaining it at this level until December 2005.

Against this backdrop, the ECB implemented fundamental changes to its monetary policy strategy in May 2003, albeit grudgingly and reluctantly. First, the inflation target was changed. The target inflation rate should now remain below 2 per cent, but “close to 2 per cent over the medium term” (ECB 2003: 98). Obviously, international and public pressure had persuaded the ECB to include deflation risks in its inflation target. Indeed, with very low inflation rates, there is a great danger that an economic shock will trigger deflation, which then leads to cumulative negative effects. Second, the ECB reduced the importance of M3growth. The Governing Council “decides that it will no longer conduct a review of the reference value on an annual basis” (ECB 2003: 98). One wonders what role the analysis of the money supply should still play if the annual growth of it is not given any special attention. In fact, the ECB has abandoned monetary targeting and the development of money supply is at best one indicator among many. Since 2003, the ECB has pursued a purely discretionary monetary policy with the aim of bringing inflation close to the 2 per cent target. The ECB, it appears, had to experience the absence of a stable link between M3-growth and inflation rates to give up monetary targeting. For example, the strong increase in M3 in the EMU after the end of the dot-com boom can be explained by rising liquidity demand. Wealthy people disinvested from collapsing equities and long-term interest-bearing securities and increased their holding of short-term monetary wealth and increased M3 without any central bank action. M3-increase in this period was a signal of crisis and not of a booming economy with inflationary pressures. Changes in M3-growth also can be due to processes within the financial markets that do not affect the real economy. Moreover, the search for a suitable monetary aggregate that could be controlled by central banks had proved to be very difficult. Finally, the refinancing rate was a weak instrument to control a monetary aggregate in certain economic conditions, even if a central bank wanted to. So it is not surprising that even those central banks that were strongly rooted in neoclassical thinking, and were devotees of Milton Friedman, one by one had to give up monetary targeting from the early 1980s onwards. The ECB, first strongly influenced by the Deutsche Bundesbank, is no exception – although it came to this last in the Western world. The Fed’s monetary targeting phase was relatively short. In the autumn of 1979, under Chairman Paul Volcker, it switched to stronger controls of monetary aggregates. However, the growth of monetary aggregates proved to be extremely unstable in the United States. At the same time, the Fed in trying to control a monetary aggregate had to accept extremely high volatility in money market interest rates. Consequently, as early as October 1982 the Fed relegated the importance of monetary targeting to the background, not least because of the outbreak of the Latin American crisis. But it was not until 1987 that it abandoned the announcement of growth targets for monetary aggregates. Finally, in 1993 Alan Greenspan declared that money supply aggregates no longer play a role in the Fed’s monetary policy (Mishkin 2001).

We believe that the ECB’s policy to give up monetary targeting and announce an inflation target close to 2 per cent which has to be realized in the medium term is an improvement. Announcing an inflation target helps to create a nominal anchor for the economy and transparency for economic agents. A different question is whether a central bank should have only one target. In the Federal Reserve Act it is written: The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. (Board of Governors of the Federal Reserve System 2020: para 1)

Thus, in comparison to the ECB the Fed has high employment, GDP growth and a low long-term interest rate as a target. Overall the Fed’s official task is more employment friendly than that of the ECB. But in both cases a nominal anchor makes sense – even if, as in the case of the Fed, the inflation target has to be weighed against other objectives. After all, the inflation target has to be of particular importance to any central bank. Inflationary processes gradually lead to the erosion of monetary functions and thus also to the erosion of a monetary production economy which results in deep economic and social crises. By setting a nominal anchor, which the bank tries to realize in the medium term, it signals that a low inflation rate plays a decisive role in the functioning of a capitalist economy. The Fed had long refused to fix the inflation target in quantitative terms. This changed in January 2012 at the urging of the then Chairman of the Board of Governors, Ben Bernanke, when an official medium-term inflation target of 2 per cent was announced. It should be stressed that the Fed defined a core inflation rate as its target, this means the inflation rate is calculated with a basket of goods and services without volatile energy and food prices (Stiglitz 2020: 82). Also Bernanke made it clear that announcing an inflation target was not a change to an inflation targeting strategy that does not take employment into account. And he added: “We are not absolutists, if there is a need to let inflation return a little bit more slowly to target to get a better result on unemployment, then that is something that we would be willing to do” (Reuters 2012: para 1). To return to the ECB’s monetary policy after its abandoning monetary targeting, GDP growth rates in the EMU rose in the years after 2003 to relatively high levels. Starting in 2005, the ECB felt compelled to gradually increase its refinancing interest rates. In 2007, the inflation rate reached a level of 4 per cent. However, this was primarily down to the rise in commodity prices. In June 2007 the main refinancing rate was increased to 4 per cent. Overall, the ECB followed a version of an inflation targeting strategy and did not want the upswing in the EMU to become inflationary. However, the relatively favourable developments in the EMU as a whole until 2007 conceal fundamental differences between the individual EMU countries. More importantly,

the first phase of the EMU (up to 2007) led to a build-up of instability, which then unleashed itself in the financial market crisis and the Great Recession. Before analysing this in detail, the theoretical background of ECB’s monetary policy after the end of the two-pillar strategy needs to be explained.

Monetary policy in the tradition of Knut Wicksell The Swedish economist Knut Wicksell (1898) introduced the concept of a “natural” interest rate that equalizes net investment and saving in the economy. Following the neoclassical tradition, in his approach investment is essentially determined by the physical productivity of capital and saving by the propensity of the population to save. According to Wicksell, the natural interest rate, which is not empirically observable, is historically unstable and subject to potentially strong fluctuations. The money interest rate is set by the central bank. The important argument Wicksell raises is that if the money interest rate is higher than the natural rate, the price level drops. Conversely, if it is lower, prices rise. A central bank that wants to achieve a stable price level must therefore constantly follow the natural interest rate with its interest rate policy. This is the only way to keep a stable price level. The monetary policy of many central banks in developed countries, after the failure of monetary targeting, is based on this very model. Mario Draghi, president of the National Bank of Italy from 2006 to 2011 and then president of the ECB until 2019, affirms this: As a consequence, the natural rate of interest – which is the real interest rate that balances desired saving and planned investment, at a level consistent with output being at potential and stable prices – has fallen over time, to very low or even negative levels. And whatever the drivers behind this, central banks have to take it into account and cut their policy rates to commensurately lower levels. Indeed, the way standard monetary policy works is to steer real short-term interest rates so that they ‘shadow’ the natural rate, which keeps the economy in balance and prices stable. When inflation is below our objective and there is a negative output gap, monetary policy has to bring real rates below the natural rate to provide enough demand support. And when inflation is above our objective and the output gap is positive, the reverse is true. (Draghi 2016: para 9f.)

In order to adjust long-term interest rates to fit this monetary policy, Draghi recommends a forward guidance strategy which the ECB first mentioned in 2013. “Forward guidance” simply means that a central bank clearly communicates to the public its medium-term objectives and strategies as well as its judgement of the economic situation. A reduction in the refinancing interest rates, to offer an example, combined with a signal by the central bank that refinancing rates will remain low in the medium-term, will, it is hoped, also bring longterm interest rates down. Such a signal might also increase the investment demand of the enterprise sector (ECB 2017). Forward guidance is not only pursued by the ECB, but also by most central banks, in particular the Bank of England and the Fed. In the tradition of Wicksell, the ECB and Draghi (2016) argued that after the financial

crisis of 2007/08 the natural interest rate dropped to very low levels. According to Draghi (2016) there are two main reasons for this. First, the secular decrease of productivity growth coupled with pessimistic expectations brought the natural interest rate down. Second, there is a global overhang of planned savings over planned investment, partly fed by ageing societies. Ben Bernanke (a member of the Fed 2002–05 and Chair 2006–14) talks about “a global saving glut” and has similar arguments: I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving – a global saving glut – which helps to explain … the relatively low level of long-term real interest rates in the world today. The prospect of dramatic increases in the ratio of retirees to workers in a number of major industrial economies is one important reason for the high level of global saving … As we will see, a possibly more important source of the rise in the global supply of saving is the recent metamorphosis of the developing world from a net user to a net supplier of funds to international capital markets. (Bernanke 2005)

Other central banks use similar arguments (Black et al. 2018: 56ff.). Wicksell’s vision of monetary policy has three weaknesses. First, in Wicksell’s thinking the natural interest rate is determined by a real sphere, but there is no real sphere independent of a monetary sphere. Or to express it differently, models with such a dichotomy between the money and the real sphere follow a wrong abstraction of the economy, at least according to Keynes (1933, 1936). In Keynesian thinking there are also two rates of return, which are important for the dynamic of an economy. Investment decisions depend on a largely expectation-driven rate of return for investment and also on the money interest rate. The expected rate of return of investment, which Keynes (1936) named “marginal efficiency of capital”, is not based on any kind of marginal productivity.6 It depends on a large number of historically specific and, in principle, uncertain factors. This makes it understandable why the marginal efficiency of capital is very unstable. If the marginal efficiency of capital is higher than the money interest rate, investments are made. In the opposite case investments do not take place. Thus monetary policy has to shadow the marginal efficiency of capital and not a natural rate. Second, even if it is accepted that an interest rate exists that can make net investment equal to savings, there is a further fundamental problem. In Keynes’ Treatise on Money (1930), he had used the approach of a natural rate in the tradition of Wicksell, however later in the General Theory he writes: “I had, however, overlooked the fact that in any given society there is … a different natural rate of interest for each hypothetical level of employment” (Keynes 1936: 242). There are many equilibriums in an economy for which planned savings and planned net investment are equal. In the Keynesian logic a certain constellation between the marginal efficiency of capital and the money interest rate determines investment and a given investment volume via the income creation process creates the savings, which then become equal to net investment. Such equilibrium between savings and net investment is possible at any level of employment or unemployment. High

employment may be prevented even when the money interest rate is zero – a situation which developed after the financial market crisis 2007/08. Thirdly, an inflation target is not easy for a central bank to achieve. Equalizing the money interest rate with the natural interest rate is too simple an approach. Inflationary pressure is in most cases driven by increasing costs. Costs depend first of all on unit labour costs and, in case of high imports in relation to GDP, on exchange rate movements (see below). Unfavourable labour market institutions can lead to a situation in which a reduction of unemployment quickly leads to increasing wages, increasing unit labour costs and increasing inflation. In such cases the realization of the target inflation rate, even if economically necessary, creates high costs in the forms of low GDP growth and high unemployment. This problem for central banks is captured by the NAIRU (Non-Accelerating Inflation Rate of Unemployment) debate. The NAIRU shows an inverse relation between the unemployment rate and inflation rate and, as nominal wage changes are behind the inflation rate, between unemployment rate and nominal wage increases (Herr 2014). To realize the inflation target the central bank has to drive the interest rate and reduce GDP growth to the level at which wage pressure reduces to such an extent that the target inflation rate is realized. Dysfunctional wage bargaining systems can also lead to decreasing unit labour costs and deflationary pressure. Because of the asymmetric power of central banks, monetary policy has alone had great difficulty in achieving the inflation target and preventing deflation. Japan after the mid-1990s offers a good example of this in practice (cf. Herr 2015). It would make monetary policy easier and more efficient if the ECB debated these problems and recommended wage bargaining systems and wage coordination that are supporting monetary policy. In spite of these criticisms, Wicksell’s framework is without doubt an improvement compared with the approach of the quantity theory of money and monetary targeting. In the quantity theory of money a stable real economy is assumed and a passive central bank that follows a simple rule is recommended. In Wicksell’s model the real economy is unstable and the central bank has to shadow the unstable natural rate with discretionary interest rate policy. The latter approach helps to stabilize an inherently unstable capitalist economy.

7 INCREASING ECONOMIC FRAGILITY IN THE EMU BEFORE THE FINANCIAL CRISIS

Independent of the two-pillar strategy of the ECB overall development of the EMU conceals different developments in different member states. It would overburden this short book to cover all EMU countries in detail, so we have chosen to concentrate on the larger countries Germany, France and Italy, as well as on those countries which were the focus of attention after the outbreak of the financial market crisis (Greece, Ireland, Portugal and Spain, which together with crisis-ridden Italy are referred to as the PIIGS countries).

Interest rates, asset bubbles and GDP growth A look at the real GDP growth rates before 2008 shows that Germany did not perform very well in the first phase of the EMU compared to other countries (see Figure 7.1). If one takes the real GDP in 1998 as the basis, then the German real GDP rose by 15.1 per cent up to 2007. Only Italy with 14.2 per cent fared worse. Portugal also counts among the group of countries with low growth with 17 per cent. In contrast, Ireland with 73.3 per cent, Spain with 40 per cent and Greece with 41 per cent experienced strong growth in real GDP for this period. The middle group during this period included France with a growth rate of 22.5 per cent, Austria with 25.4 per cent and the Netherlands with 25.7 per cent. By way of comparison the United States achieved growth of 29.8 per cent (OECD 2020).1

Figure 7.1 Real GDP in selected EMU countries, 1998–2018 (Index 1998 = 100) Source: OECD (2020), real GDP forecast (indicator).

The different growth rates result from the different macroeconomic regimes that prevailed in the respective countries. A first indication is provided by the development of long-term interest rates. Figure 7.2 shows the interest rates of government bonds with a ten-year maturity. These serve as a reference for long-term loans to the private sector, which usually has to pay slightly higher interest rates. Long-term interest rates are important for corporate investment and for household real estate purchases. Germany had the lowest interest rates before the start of EMU, as the D-Mark was the leading currency in the EMS (see Chapter 2). This was particularly true for countries such as Spain, Portugal and Greece. But countries such as Ireland and France also had higher interest rates than Germany. With the start of the EMU, the long-term interest rates of all EMU participants fell to the German level. Until the outbreak of the financial market crisis, long-term interest rates were almost identical in all EMU countries. In addition, the interest rate level in the 2000s was generally at a low level, as recovery from the dot-com bubble had led to a prolonged expansive monetary policy.

Figure 7.2 Long-term interest rates in selected EMU countries, 1989–2019 Source: OECD (2020), long-term interest rates (indicator).

These developments were particularly beneficial for the countries with previously weak currencies. It was the starting signal for a big spending spree, especially in the real estate sector. The substantial drop in interest rates drove up asset prices and encouraged private households and companies to invest in real estate. At the same time loans were easy to obtain. Expectations of the agents in the non-financial and financial sectors were positive. Expectations of further increases in real estate prices attracted speculators, which in turn increased the demand for real estate assets. It became an ideal breeding ground for a real estate boom. A huge real estate bubble developed in a number of EMU countries, which burst in 2008 – about a year after the end of the real estate bubble in the United States (see Figure 7.3). According to the OECD housing prices indicator, between 1998 and 2008 house prices rose by almost 200 per cent in Spain and Ireland, around 150 per cent in France, and over 100 per cent in Greece and Italy. The increase was comparatively small in Portugal at around 25 per cent. Germany differed markedly from all the countries mentioned, with house prices actually falling by 1.9 per cent over the same period.2 According to this index, real estate prices in the United States rose by 79 per cent between 1998 and 2006 (the end of the increase). This was relatively low compared to some of the EMU countries (OECD 2020).

Figure 7.3 House prices in selected EMU countries, 1998–2018 (Index 1998 = 100) Source: OECD (2020), housing prices (indicator).

Share prices in the EMU also experienced a massive bubble. Figure 7.4 shows the crash of share prices after the end of the dot-com boom in 2001. Subsequently a huge new stock market bubble built up until it burst in 2007/08. Share price increases in Spain, Portugal, Ireland and Greece were especially high. In Greece the development was extreme with share prices increasing by around 350 per cent between 2003 and 2007, followed by an equally deep fall. Overall share prices in the EMU increased from their lowest value in 2003 to their highest in 2007/08 by 137 per cent, in the United States the increase was 116 per cent (OECD 2020). Overall, asset bubbles in the EMU before the Great Recession were much stronger than in the US.

Figure 7.4 Share prices in selected EMU countries, 1999–2019 (1999 = 100) Source: OECD (2020), share prices (indicator).

Asset price bubbles are dangerous for the stability of economies, particularly real estate bubbles. Real estate investment is usually a large tranche of a society’s total investment and it is associated with strong credit expansions. Additionally, real estate prices can jump to very high and unsustainable levels as excess demand in the market cannot be met quickly as building new stock takes time. Closing this gap can take years. Finally, even if increasing real estate prices are driven by fundamental issues of supply, speculators are attracted by the market and exaggerate the effect. Stock market bubbles can in turn be driven by credit expansion and speculation. When the rise in asset prices comes to an end and gives way to asset deflation, loans can no longer be serviced and supposedly secure collaterals lose their value. A financial crisis which affects the whole economy can develop. The basic structures of such bubbles have long been known in economic theory (Minsky 1975; Kindleberger & Aliber 2015; Detzer & Herr 2015a; Goodhart & Tsomocos 2019). In the EMU, the 2000s’ bubble developed in a textbook manner. It was associated with massive credit expansion. Table 7.1 shows how the net financial assets of a country’s various economic sectors changed as a percentage of national GDP for selected EMU countries between 2001 and 2009. In Greece there has been a massive deterioration in the net financial asset position of (private) households (by 71 per cent of GDP) and of the country as a whole (by 60 per cent of GDP). In contrast, companies in the non-financial sector did not incur any further debt as measured by GDP. Obviously, the high indebtedness of private households was accompanied by weak investment activity on the part of enterprises. Spain also occupies

an extreme position. The net financial asset position of households has fallen by 31 per cent of GDP and that of the business sector by 40 per cent of GDP, suggesting a high level of household indebtedness and, at the same time, a high level of investment by enterprises. Spain’s external asset position deteriorated by 52 per cent of GDP. In Ireland, the net financial asset positions of households decreased by 38 per cent, of the government by 15 per cent and the country as a whole by 56 per cent of GDP. Also in Portugal the net financial asset position of the country fell sharply by 58 per cent of GDP. In Italy and France developments were more moderate. These developments are mirrored in Germany. Here the net financial asset position of private households improved by 32 per cent of GDP and the external position by 26 per cent of GDP. Table 7.1 Net financial assets by sector in selected EMU countries (% of national GDP), 2001 and 2009 Sector 2001 2009 Change Greece Households 131 59 −71 Government −93 −87 6 Financial Sector −9 −6 3 Non-Financial Sector −71 −69 2 Total -42 -102 -60 Ireland

Households Government Financial Sector Non-Financial Sector Total

103 −13 −2 −103 -15

65 −28 1 −105 -67

−38 −15 3 −2 -52

Italy

Households Government Financial Sector Non-Financial Sector Total

202 −96 2 −99 9

186 −103 19 −117 -16

−16 −7 17 −18 -25

Portugal

Households Government Financial Sector Non-Financial Sector Total

140 −30 −10 −148 -48

127 −57 −1 −174 -106

−13 −27 9 −26 -58

Spain

Households Government Financial Sector Non-Financial Sector Total

107 −42 3 −103 -34

76 −34 11 −143 -90

−31 7 7 −40 -56

France

Households Government Financial Sector Non-Financial Sector Total

118 −37 11 −77 15

131 −51 19 −102 -2

14 −14 8 −25 -17

Germany

Households Government Financial Sector Non-Financial Sector Total

98 −36 0 −58 4

130 −48 7 −59 30

32 −12 7 −1 26

Note: the total sums capture the country’s net creditor or debtor position vis-à-vis the rest of the world. Source: Chen et al. (2013), based on Eurostat statistics and OECD statistics.

Looking at the credit flows it becomes clear that 80 per cent of financing for the deficit countries in the EMU came from other EMU countries and only about 20 per cent from outside the EMU (Hale & Obstfeld 2016). The main creditor country was Germany (Chen et al. 2013). Loan flows from outside the EMU went primarily to Germany, which then served as a financial hub for granting loans to EMU countries with strong credit expansion. Despite small differences in interest rates, the German financial system was able to generate high profits from this “version of carry trade” within the EMU. Carlo Bastasin (2012: 10) explains: German banks could get money at the lower rates in the eurozone and invest it for a decade in higher yielding assets: for much of the 2000s, those were not only American toxic assets but the sovereign bonds of Greece, Ireland, Portugal, Spain, and Italy. For ten years this German version of the carry trade brought substantial prots to the German banks ‒ in the order of hundreds of billions of euros.

The high growth rate, especially in Greece, Spain and Ireland, was directly related to the strong demand for real estate, the resulting boom for the construction industry and high consumer demand. The latter was based on positive income and employment effects as well as the positive wealth effects of asset market inflation. In other parts of the EMU, especially in Germany, this economic stimulus did not exist. It is incomprehensible that, from 2005 onwards, the ECB did not concern itself with the

extreme developments in property prices within the currency area. One might have expected the ECB to bring the problem of real estate bubbles into economic policy debates. It did not, however. Perhaps like Alan Greenspan, who made the following statement at a hearing in a congressional committee in October 2008: “Partially … I made a mistake in presuming that the self-interest of organizations, specifically banks, is such that they were best capable of protecting shareholders and equity in the firms … I discovered a flaw in the model that I perceived is the critical functioning structure that defines how the world works” (Greenspan 2008: para 15). Obviously, like many others, he was blinded by the theory of efficient financial markets, which, along with financial sector lobbying, provided the breeding ground for the deregulation of the financial system from the 1970s onwards. The ECB can be given credit that monetary policy became much more complicated after the liberalization of real estate markets without adequate regulation (Cardarelli et al. 2008).

Wages, unit labour costs and prices The development of nominal wages is shown in Figure 7.5. From 1996 until the launch of the EMU in 1999 there was no correction of exchange rates and changes in competitive conditions related to it. It is immediately noticeable that Germany recorded the lowest increase in nominal wages between 1996 and 2007 (17.9 per cent). Increases were particularly strong in Ireland and Greece (about 100 per cent). In Portugal, they also amounted to a remarkable 57.9 per cent. In Spain (39 per cent) and France (36.7 per cent) the increases were more moderate but still much higher than those in Germany (OECD 2020).

Figure 7.5

Nominal labour compensation per hour worked in selected EMU countries, 1996–2018 (1996 = 100)

Source: OECD (2020), labour compensation per hour worked (indicator).

Based on the Keynesian approach, nominal unit labour costs are the central determinant of price levels (see Chapter 5). In a monetary union, regional developments in unit labour costs play a decisive role in regional price competitiveness. By definition, changes in unit labour costs result from increases of nominal hourly wages minus increases of (labour) productivity. If the development of unit labour costs is to become an anchor for the desired price level development, nominal wages in the EMU would have to rise by about 3.5 per cent annually. This is because productivity in the EMU is rising by around 1.5 per cent and the targeted increase in the price level is just under 2 per cent. The precondition that the target inflation rate in a monetary union in the medium term can be realized and regional price competitiveness does not change is that in each member state nominal wages increase according to regional trend productivity plus the target inflation rate of the central bank. After the creation of the EMU only the first condition was more or less fulfilled. But nominal wage developments in most countries did not reflect the target inflation rate of the ECB (see Figure 7.6; and Herr & Horn 2012). Unit labour costs in France have risen almost perfectly in line with the desired wage development. Between 1996 and 2007, unit labour costs rose by a total of 26.6 per cent. This corresponds to an annual growth rate of 2.17 per cent. In Germany unit labour costs between 1996 and 2007 fell by 0.4 per cent. Wage increases in Germany were thus only in line with the relatively good productivity trend. Germany was thus seriously below a wage trend that would have stabilized the EMU. Unit labour costs in Italy were slightly too high compared with France. In Greece and Ireland, despite relatively good productivity growth, unit labour costs rose sharply as a result of very high nominal wage increases. Unit labour costs in Greece increased overall by 58.2 per cent and annually 4.3 per cent on average; in Ireland the numbers are 44.4 per cent and 3.4 per cent. Wage increases in Spain were also too high compared with a functional wage development. In Spain, productivity growth stagnated completely over the period. Unit labour costs in Spain rose by 37.1 per cent between 1996 and 2007, i.e. by an average annual growth rate of 2.9 per cent. Portugal, with a relatively good productivity performance, recorded an increase in unit labour costs of 35.6 per cent or an average annual growth rate of 2.8 per cent (OECD 2020). It can be seen that even relatively small differences in annual growth rates add up to large absolute differences over the course of a decade. To sum up, the variation in changes of unit labour costs in the EMU before the financial market crisis were enormous. Wage increases in Germany were much too low. If Germany were a small country like Austria, Germany’s dysfunctional wage policy would not have had such devastating consequences for the price competitiveness of the other countries. But with almost 30 per cent of EMU’s GDP, Germany is a heavyweight in the eurozone. As a result, it massively impaired economic development in the other countries. Even France, with its highly functional wage policy, clearly lost competitiveness to Germany. Wage increases in

Greece, Ireland, Portugal and Spain were too high compared to a functional wage policy.

Figure 7.6 Nominal unit labour costs in selected EMU countries, 1996–2018 (1996 = 100) Source: OECD (2020), unit labour costs (indicator).

Differences in wage and unit labour cost developments reflect differences in national wage formation systems and strategies of trade unions (Du Caju et al. 2008). Obviously, one of the major shortcomings in the creation of the EMU was the lack of sufficient institutionalization to coordinate wage developments. There was and there is no EMU minimum wage and no EMU-wide wage negotiations even in central industries or in the public sector. Trade unions, employers’ associations and wage bargaining systems are exclusively national. A form of transnational coordination, however organized, or even binding agreements, is not even in its beginnings discernible. This must be regarded as highly dysfunctional for a monetary union. The German trade unions, for example, have a strong macroeconomic and partially mercantilist orientation. Already in the 1950s, a productivity-oriented wage development prevailed in Germany, even if it was not perfectly implemented. Wage negotiations in Germany typically begin in the metal industry with the strongest German trade union, which uses the productivity development of society as a whole and the competitiveness of the German economy as central guidelines in wage negotiations. The outcome of wage bargaining in the metal industry then has a high signalling function for all other industries. This distinguishes Germany from most other member states of the EMU. However, German unification in 1990 and massive deregulation of the labour market in the early 2000s – the so called Hartz Reforms – have reduced this signalling function and wage bargaining coverage in general. A dual labour market has since emerged. The smaller

companies that operate in the services sector are more likely not to raise nominal wages or only very slightly from the mid-1990s onwards. From a regional point of view, East Germany was particularly affected by this development. In Germany the low-wage sector exploded. In 2015 a long overdue minimum wage was introduced in Germany. These developments in the German labour markets are part of the explanation for the inappropriate wage restraint in Germany. The cause of high wage increases in Greece and Ireland in particular, but also in some other countries, is manifold. One reason is certainly that GDP growth and consequently employment improved from 2004 onwards. Other factors, such as specific wage-setting mechanisms, lack of inter-sectoral wage coordination or divergent developments of minimum wages also can explain different wage developments. The most plausible thesis seems to us to be that the bargaining parties followed the traditional wage policy before the creation of the EMU and did not take into account that they are now in a monetary union and cannot make exchange rate adjustments so price competitiveness is lost. If one compares the wage formation mechanism in the EMU with that in the United States, there are much stronger coordination instruments in the US. First of all, there is a minimum wage in the US across the entire currency area, which can then be increased by individual states or even cities. The US has certain wage coordination for the public sector and for some other sectors, as there are national trade unions and employers’ associations. In addition, through common media and social debates on wage development, a certain nationwide understanding of how wages should develop in a wage-round emerges. These coordination mechanisms in the US are relatively weak, but in the EMU even these do not exist. Well aware that the lack of wage coordination could become problematic in the EMU, the Macroeconomic Dialogue of Social Partners was launched in 2009 on the initiative of the European Council. Representatives of the ECB, the ECo, the European Council and the top European representatives of the social partners meet twice a year to discuss developments in the EMU (Koll & Watt 2017). The Macroeconomic Dialogue is exclusively a forum for informal information and consultation. The organizations of the collective bargaining parties represented there are extremely weak at European level and are therefore of no relevance to national collective bargaining. The dialogue has so far been unable to achieve anything relevant. Overall, the ECB has a negligible direct influence on social partners. Of course, indirectly the influence of monetary policy on wage development does exist via influencing GDP growth and unemployment. However, the ECB is helpless, if wage costs diverge regionally or do not rise sufficiently. Figure 7.7 shows the development of the consumer price index in selected EMU countries. Not surprisingly, the price level increase in Germany is low compared to the southern European EMU countries and Ireland. These figures demonstrate the decisive role

of wage developments for price level changes.

Figure 7.7 Consumer price index in selected EMU countries, 1998–2020 (1998 = 100) Source: OECD (2020), inflation (CPI) (indicator).

The relatively high inflation rates in parts of the EMU meant that real interest rates in the affected regions were partly negative. This has further driven the development of real estate bubbles. In Germany, on the other hand, real interest rates were relatively high. It should also be noted that real wages in some countries with relatively high nominal wage increases did not increase. In the EMU until 2007 real wages per hour (deflated by the consumer price index) almost did not increase in Spain or Portugal, also in Germany real wages stagnated. Real wages increased substantially in Greece, Ireland and France (OECD 2020).

Current account imbalances It is a truism that regions with declining price competitiveness and relatively strong growth create current account deficits compared to regions with increasing price competitiveness and weak growth. Figure 7.8 shows this for the EMU. The size of current account deficits as a percentage of GDP which developed in the first phase of the EMU was enormous in some countries. In 2007 the deficit was 15.2 per cent of GDP in Greece, 9.7 per cent in Portugal, 9.6 per cent in Spain, 6.5 per cent in Ireland. By contrast, Germany coming from a current account deficit in the 1990s increased its current account surplus to 6.9 per cent of GDP. In

France the current account was roughly in balance and in Italy the deficit was small at 1.4 per cent. The EMU as a whole had a balanced current account balance in 2007 (OECD 2020). Thus, in the second half of the 2000s massive current account imbalances had developed in the EMU, which were financed primarily within the EMU by corresponding capital flows. A number of investigations came to the conclusion that growth differences played the major role in these imbalances, but also price competitiveness caused by the development of unit labour costs played a role. Horn and Watt (2017: 31) calculated that “even if nominal wages had risen by almost 15 per cent above the status quo over a 15-year period, Germany’s current account surplus in 2015 would have been just 6 per cent lower” (see also Stockhammer et al. 2011; Schröder 2015). This also means that extreme wage adjustments would be needed to reduce the current account imbalances within the EMU.

Figure 7.8 Current account balances in selected EMU countries (% of GDP), 1998–2018 Source: OECD (2020), current account balance (indicator).

Fiscal policy Fiscal policy is of great importance for the success or failure of monetary policy. It can support monetary policy, but it can also neutralize it. An expansive monetary policy can be counteracted by a restrictive fiscal policy. There are also situations in which monetary policy has little effect, so fiscal policy becomes the economic lever. This is the case when refinancing interest rates are zero, but the stagnating economy does not start to grow. For this reason, coordinated monetary and fiscal policy is vital for delivering macroeconomic management. Typically, a central bank has a central government as its partner and can agree

on a coordinated approach. This also applies if the central bank is institutionally independent. In order to understand developments in the EMU, it is important to recognize that the ECB does not have a fiscal partner. There is no central fiscal institution in the EMU and without it no central fiscal policy. After the creation of the EMU, fiscal policy was subject to the SGP (see Chapter 3). Budget deficits, apart from very deep economic crises, were not allowed to exceed 3 per cent of GDP. Until the outbreak of the financial market crisis in 2007/08, the EMU as a whole had moderate budget deficits. After the bursting of the dot-com bubble and the subsequent low growth period budget deficits were around 2 per cent of GDP. They then increased to 3.2 per cent in 2003 and 3 per cent in 2004 and decreased until 2007 to 0.7 per cent of GDP. The US followed a completely different path. Here deficits in per cent of GDP rose from 1.9 per cent in 2001 to 6.4 per cent in 2003. In 2004 they reached 4.5 per cent and were only reduced to 4 per cent of GDP by 2007 (OECD 2020). The US was thus clearly more anti-cyclically oriented than the EMU and did not step on the fiscal brake at the first signs of an economic recovery. It is noteworthy that Germany, the driving force behind the SGP, was unable to meet the 3-per-cent limit despite strong public austerity efforts (Figure 7.9). Between 2001 and 2005, Germany violated the Pact – most severely in 2003 with 4.2 per cent of GDP. In 2007 it then had a slight surplus. Spain always fulfilled the SGP until the onset of the financial market crisis and even had budget surpluses from 2005 to 2007, the highest in 2006 with 2.2 per cent of GDP. Ireland, apart from 2002, also had budget surpluses in the entire period up to 2007. Greece, on the other hand, fell out of line with high budget deficits, in spite of extraordinarily high GDP growth. In every year between 1999 and 2007 Greece violated the 3-per-cent limit and, for example, in 2003 with 7.8 per cent of GDP, 2004 with 8.8 per cent and 2007 with 6.7 per cent. Portugal, with relatively poor growth after the start of EMU, also violated the Pact every year. Finally, France and Italy also moderately breached the conditions of the SGP, France from 2002 to 2005 and Italy from 2001 to 2006.

Figure 7.9 Budget deficit in selected EMU countries (% of GDP), 1998–2018 Source: OECD (2020), general government deficit (indicator).

The debt ratios, which according to the SGP should, in countries with high public debt, at least move towards the maximum limit of 60 per cent of GDP, showed similar failures (see Figure 7.10). Spain and Ireland, which had debt levels of 41.8 per cent and 27.5 per cent respectively in 2007, were model pupils with falling debt ratios. Italy was able to reduce its debt stock from 123.7 per cent in 1999 to 110.7 per cent in 2007. For the other countries, however, the development was not in line with the SGP. Germany slipped from a debt ratio of less than 60 per cent to a value of just over 60 per cent. For a number of countries, debt ratios rose even more markedly, reaching 75.9 per cent in France, 78.1 per cent in Portugal and 112.9 per cent in Greece in 2007. By way of comparison, the public debt ratio also rose in the US, from 76.2 per cent to 86.4 per cent (OECD 2020).

Figure 7.10 Government debt in selected EMU countries (% of GDP), 1998–2018 Source: OECD (2020), general government debt (indicator).

Overall, it can be said that the SGP failed in the first phase of the EMU as many countries, including the large ones, violated it. Even worse, not following the philosophy of the SGP most EMU countries had in the last phase of the cyclical upswing no balanced government budgets or even surpluses. This meant that they had no chance of meeting the 3-per-cent limit in the subsequent economic slump. During this period, the ECo attempted to enforce compliance with the Pact with the help of sanctions against “sinners”. These sanctions required the agreement of ECOFIN, which ultimately claimed the decision-making power for itself. Under the leadership of Germany and France, however, ECOFIN decided not to impose any sanctions. The ECo appealed to the European Court of Justice to clarify whether ECOFIN could systematically waive sanctions in the event of a violation of the SGP, contrary to the recommendation of the ECo. In 2004, the Court ruled in favour of ECOFIN. The violation of the SGP by so many countries inevitably led to discussions as to whether the Pact was sensibly conceived and ultimately led to a modification of the SGP by the EU heads of government in 2005. The 3-per-cent limit was maintained, but there were a number of reasons, not previously mentioned, that allowed violations. For example, a negative GDP growth rate – not specifically, as before, a decline in GDP of more than 0.75 per cent – was seen as sufficient to be able to realize a budget deficit of more than 3 per cent of GDP. In addition, the reduction of the budget deficits should take place over the medium term in the case of a misdemeanour and not as before in the short term. In a number of additional “extraordinary events” the deficit could rise over 3 per cent of GDP, events that were not specified in detail but examples might be reform of the pension and social systems,

expenditures for the promotion of research and development or the medium-term economic and budgetary situation. Overall, the SGP was not replaced but relaxed and could thus be dealt with more flexibly than before. Both the ECB and the Deutsche Bundesbank viewed the easing of the SGP as problematic. Euractiv (2006: para 3) writes: The European Central Bank has expressed ‘serious concern’ about the … changes to the pact. It is anxious that changes in the ‘corrective arm’ of the pact (excessive deficit procedure) do not undermine confidence in the EU’s fiscal framework and the sustainability of public finances in eurozone countries … The German Bundesbank says that the new rules have considerably weakened the pact, with fewer incentives for keeping sound public finances and enforceable rules due to the numerous exceptions and special rules … It is particularly concerned that the upper 3 per cent deficit limit has been relaxed under the excessive deficit procedure.

So, the last word has yet to be spoken on the matter. We shall return to this aspect below when we discuss the tightening of fiscal rules after the Great Recession.

Different macroeconomic regimes in the EMU In the EMU before the Great Recession different macroeconomic regimes in member countries can be distinguished (see also Hein & Truger 2007; Herr & Kazandziska 2011). A mercantilist regime is represented by Germany, but also a number of smaller EMU countries in the northern part of the EMU (Scharpf 2018). At the heart of this regime is a restrained wage policy and high current account surpluses. In Germany low wage increases in this phase were based on numerous labour market reforms in the early 2000s, which led to increasing precarious employment, growing insecurity among many employees and a weakening in the position of the trade unions. In addition, the wage formation system in Germany traditionally has led to relatively low wage increases, as the German trade unions keep an eye on international competitiveness and include macroeconomic dimensions in their strategy. Above all, the unsatisfactory income development in Germany occurred with a simultaneous increase in income inequality. Moreover, the countries in this regime did not pursue an active fiscal policy, or at least it was not used to increase the low growth rate and reduce current account surpluses. Nonetheless, government debt as a share of GDP rose moderately. Real interest rates were relatively high due to the low wage increases and the resulting low inflation rate. Private investment activity remained poor as a result of the overall lack of demand and relatively high interest rates. High current account surpluses stimulated the economy but were unable to trigger high growth. As a result, a low growth path was adopted. This kind of mercantilist market regime can by no means be followed by all countries, simply because not all countries in the world can have current account surpluses. The sum of all current account balances in the world must add to zero. Current account surpluses

stimulate domestic growth at the expense of other countries. Based on its size, Germany’s market constellation was therefore a disruptive factor for the EMU and even for the world economy. It should be mentioned that the mercantilist orientation of Germany has a long history. It shaped the German industrial structure for decades and can be considered as an important element of the German miracle after the Second World War. The mercantilist constellation is the result of a combination of factors. Monetary policy is one. Germany after the war was always oriented towards a low inflation rate. Increases of nominal unit labour costs, which would lead to an inflationary development, were rigorously fought by the German central bank with restrictive monetary policy. The Deutsche Bundesbank became a disciplinary factor for trade unions. This, together with the ability and willingness of German trade unions to implement macroeconomic strategies and, as mentioned above, take into account international competitiveness in wage negotiations, led to low nominal unit labour cost increases compared with other countries. This development was further supported by the relatively high productivity increases of the German economy. Ludwig Erhard, German minister of economic affairs from 1949 to 1963 and German head of government from 1963 to 1966, wrote to the president of the German central bank in 1950, “If we succeed … in keeping price levels relatively stable, we will be able to avoid major wage disputes … If we succeed in holding onto prices through our greater selfdiscipline than other countries can manage, then in the long run we will be more capable of exports and our currency will be weightier and healthier in itself and moreover against the dollar” (Erhard 1950; quoted in Bibow & Flassbeck 2018: 127). Low increases in unit labour costs and low inflation compared with other countries led Germany to accumulate high current account surpluses in the 1950s and economic and political pressure to revalue the D-Mark within the Bretton Woods system. This was the first time that the typical German dilemma developed: pressure to appreciate the D-Mark became strong, but to prevent the erosion of German competitiveness and current account surpluses, policies were implemented to prevent or at least slow tendencies of a strong D-Mark. Otmar Emminger (1986: 109f.), who worked for the Bundesbank his whole professional life and between 1977–79 as president, reports in his memoirs that Karl Blessing (president of the Bundesbank, 1958–69) as well as Konrad Adenauer (Chancellor) and his advisors Herman Joseph Abs (lead manager of the biggest private German bank, the Deutsche Bank), Fritz Berg (president of the German industry association, BDI3), Robert Pferdmenges (president of German banking association4) resisted the revaluation of the D-Mark for a very long time, which eventually happened in 1961. To diffuse the revaluation pressure, stimulation of German capital exports were discussed. This led to the creation of German development aid: “In August 1960, at the suggestion of Hugo Rupf, the then-president of the mechanical engineering association, discussions began

among the leading circles of German industry to raise considerable means for financing development aid via the borrowing of long-term bonds … Many regarded this development aid loan as a ransom that the economy had to pay to avoid a revaluation” (Emminger 1986: 112). Independent of this, the Deutsche Bundesbank intervened heavily in foreign exchange markets to prevent an appreciation of the D-Mark. Such interventions were the single most important factor between 1951 and 1973, the year the Bretton Woods system broke down, of central bank money creation in Germany (Emminger 1986: 36). It is also noteworthy that the Deutsche Bundesbank was sceptical about the increasing international role of the D-Mark – mainly because of exchange rate turbulences and appreciation pressure of the D-Mark. In the late 1970s the US dollar became very weak against the D-Mark: “During the crisis of confidence in the dollar, from 1977 to 1979, we made it abundantly clear that we vehemently opposed the role of D-Mark as an alternative reserve currency. From this the slogan then came about ‘D-Mark as reserve currency against our will’ ” (Emminger 1986: 44). This tendency towards German low nominal unit labour cost increases continued when the EMU was created. Two points are important: the development of German low-wage cost increase could no longer be compensated for in the EMU by appreciations of the D-Mark; and, before the EMU, Germany had one of the lowest real interest rates in the world as the Bundesbank wanted to slow down capital imports. In the EMU German real interest rates became relatively high as the ECB had to orient its interest rate policy toward the development of the whole monetary union. This is one factor that explains the low investment dynamic of Germany after the creation of the EMU. Greece, Spain and Ireland in particular found themselves in a debt-driven macroeconomic regime. These countries experienced a strong real estate and stock market bubble and high levels of construction activity. High wage increases led to relatively high inflation and low real interest rates. Firms and the private household sector accumulated high debt. Demand and the economy were booming. Strong domestic demand in Greece was also fuelled by an expansive fiscal policy. In Greece, government debt as a share of GDP rose during this phase, while in Spain and Ireland the share fell sharply partly based on budget surpluses. Along with high GDP growth and relatively high wage and price increases the countries in the debt-driven macroeconomic regime built up very high current account deficits. As a result, their foreign debt increased considerably. This kind of macroeconomic regime is not sustainable in the long-run and is dangerous as asset bubbles burst sooner or later; debtors in the phase of asset market deflation are unable to repay their loans; and typically a sudden credit crunch hits and the economy goes into recession. High current account imbalances within a monetary union are not as dramatic as between different countries. This is because in a monetary union debt between different regions is in domestic currency. And in normal monetary unions there are a variety of mechanisms which

stabilize regions in crisis, such as a common deposit guarantee and bankruptcy procedures for banks, nationwide social security systems, fiscal help from the centre for highly indebted regional public households, etc. The next chapter makes it clear that none of these stabilizing mechanisms existed in EMU when it was hit by the first crisis. France in this phase was typical for a sustainable domestic demand driven regime. This regime provided a viable model for sustainable development. Growth in France was slightly above that of the EMU. Wage developments in France were roughly in line with the French trend of productivity development plus the ECB’s inflation target, the current account was close to balance and the government debt to GDP ratio was stable. Without Germany’s mercantilist strategy, France’s current account would certainly have been moderately positive and growth a bit higher. Italy and Portugal were trapped in a stagnation regime with very low growth rates. In Portugal, property prices hardly rose at all. But increases in unit labour costs were relatively high despite the low growth. As a result, Portugal built up large current account deficits. In addition, due to fiscal policy and low GDP growth, the public debt stock increased as a percentage of GDP. In Italy, property prices increased somewhat more strongly, the current account remained almost balanced and the public debt stock remained at the same high level. Italy’s stagnant productivity levels, however, are notable.

Summary In the first phase of the EMU, the ECB’s monetary policy was characterized by the failure of its intended strategy for money supply management. In 2003 the ECB abandoned this strategy. It then moved onto a policy of “constrained discretion”. For this reason, it provided the commercial banks with sufficient liquidity until the outbreak of the financial crisis of 2007/8 and did not pay attention to money supply growth. However, the ECB clearly remained too passive in the face of extreme real estate bubbles, even if it lacked the adequate instruments. After all, raising interest rates to combat real estate bubbles is economically and socially extremely expensive and would have plunged the EMU into an unnecessary crisis. When comparing the ECB’s monetary policy with that of the Fed, it seems that the Fed reacts faster and more stridently to economic changes in its interest rate policy. This is suggested by Figure 7.11. The Fed’s responsiveness in raising and lowering refinancing rates in the economic cycle compared to the ECB can be interpreted to mean that the economic upswing in the US was stronger in the late 1990s and in the second half of the 2000s and that the economic turnaround started earlier than in the EMU. The sharper cut in Fed interest rates during the two economic slumps supports the view that the Fed is more aggressive in combatting economic weaknesses than the ECB. This corresponds to the fact that it supports upswings with monetary policy more than the ECB. A longer-term historical analysis shows

that it traditionally raises interest rates cautiously during economic upswings and only appreciably when inflation risks become apparent. This policy is evident with the appointment of Alan Greenspan as Chair of the Board of Governors in 1987, and remained unchanged by his successor, Ben Bernanke (Chair, 2006–14). At least in its first decade the ECB has demonstrated that it pays less attention to economic growth than the Fed. The conclusion being that the Fed pursues a more employment-friendly policy compared to the ECB overall, which is ultimately in line with its mandate (see also Herr & Kazandziska 2011).

Figure 7.11 Main refinancing rate of the ECB and the federal funds rate of the Fed, 1999–2019 Source: ECB Statistical Data Warehouse (2019); Federal Reserve Bank of the USA (2019).

As far as wage development is concerned, the sole anchoring of wage bargaining in EMU member states has proved to make for incoherent wage development. As has been shown, some countries (especially Germany) remained well below the functional wage norm for the EMU as a whole and others (especially Greece and Ireland) well above it. Now it is not possible for central banks to directly influence wage developments. However, many central banks have been very good at sending clear signals to the bargaining parties to make it clear that they would not accept inappropriate wage settlements. For example, the Deutsche Bundesbank long had a tradition for doing just that. Admittedly, communication within such a heterogeneous entity as EMU is more difficult than in normal currency areas. Despite all the objective difficulties, one could nevertheless have expected the ECB to draw public attention to the inadequacies of the wage settlements, such as the insufficient wage increases in a member state as large as Germany. The establishment of the Macroeconomic Dialogue of

Social Partners was not able to eliminate this dysfunctionality. Finally, the ECB has no fiscal partner as fiscal policy is not conducted at EMU or EU level. In the phase of weak growth after the end of the dot-com bubble, one would have wished for an EMU fiscal policy that would have driven growth similar to that in the United States. But such a policy did not exist. Rather, a jumble of fiscal policies emerged in the EMU in the 2000s. Many countries were unable to comply with the SGP. The failure of the SGP clearly shows the limitations of rigid rules in the absence of a centrally implemented fiscal policy. Overall, in this first phase of the EMU up to the financial market crisis, the ECB stood alone as the only supranational powerful institution. It was capable of learning, as it abandoned the two-pillar strategy and switched to a strategy of constrained discretion. It could certainly have gone further towards its expansionary limits in terms of monetary policy in order to support non-inflationary growth. Furthermore, it should have drawn more attention and with greater publicity to the formation of highly speculative bubbles and inappropriate wage developments in its currency area. But the ECB cannot be accused of major monetary policy mistakes at this stage and for regional developments beyond its control.

8 MONETARY POLICY DURING THE GREAT RECESSION

The ECB’s monetary policy was confronted with extraordinary challenges as a result of the financial market crisis in 2007/08, the Great Recession in 2009, the EMU’s second recession after 1999 and the outbreak of financing problems of governments in member countries in the same period. The ECB’s monetary policy was deeply influenced by fiscal policy, or rather by the lack of a fiscal partner, and general economic policy in the EMU. It will be shown that monetary policy is embedded in macroeconomic processes and policies and in a macroeconomic regime is only one player among many. In this chapter monetary policy during the Great Financial Crisis and the Great Recession is analysed.

The financial market crisis and Great Recession in the EMU In the United States, the real estate boom came to an end in 2007. An increasing number of subprime loans could not be paid back and gave their name to the biggest financial market crisis since the 1930s. However, real estate loans to households with low income and poor collateral were only the trigger of the financial market crisis. Any other segment could have caused the outbreak of the crisis as well. The financial system as a whole had become so fragile due to deregulation and innovation in previous years that a relatively small financial market segment, such as subprime mortgage credits in the US, could trigger a global crisis (Hellwig 2008; Goodhart & Tsomocos 2019). The collapse of the market for securitized loans played a large role in the deepening crisis. Good examples of these are mortgage-backed securities and collateralized debt obligations (CDOs). Mortgage credits were sold by banks to investment banks or special purpose vehicles partly owned by the banks themselves. Service of these long-term credits would now go to the investment banks or special purpose vehicles. These credits were pooled and cut in tranches. The so-called waterfall principle meant that one tranche would suffer first when credits in the pool were not serviced. Only when the first-loss tranche was completely used up, would the next tranche suffer, and so on. Investors with different appetites for risk would buy the different tranches, wherein the most risky tranche earned the highest interest rate. Frequently mortgage credits were pooled with other credits, such as consumer credits or credits to emerging countries. No buyer of such tranches could realistically estimate the risk

of such papers. Rating agencies, which were paid by the institutions pooling and selling securitized papers, failed to evaluate the risks correctly. To make matters worse, financial institutions pooling such credits showed very high maturity transformation as the securitized papers were short term. When confidence in these papers broke down, institutions pooling and selling such papers ran into deep liquidity problems. Emergency sales caused prices for securities to fall further. Supposed liquidity held in short-term securities became worthless as nobody would buy them. Credit default swaps could in no way fulfil their function, as companies that were supposed to step in in case of defaults became illiquid or even insolvent themselves. The breakdown of Lehman Brothers, the fourth largest US investment bank at the time, in September 2008 accelerated the crisis. The Lehman shock brought the money market between financial institutions to a standstill, as no institution knew how many bad loans the others held in their own or in their numerous subsidiaries’ accounts in the form of hedge funds, special purpose vehicles, etc. The financial market crisis in the US not only infected the world financial system, it also led in 2009 to the Great Recession. In Europe, a number of institutions, such as the German IKB-Bank, were already in a tailspin by mid-2007 because they had invested more heavily in securitized US real estate loans or other papers. At the same time, political leaders in Europe hoped that the crisis would not hit the continent (Bibow & Flassbeck 2018; Detzer et al. 2017). This illusion was finally destroyed when Lehman Brothers collapsed. Due to the international interdependence of the financial system, the eurozone could not turn a blind eye (Detzer et al. 2017). The problems in the financial system in the US led to a general change in sentiment in Europe and triggered the end of the real estate and equity boom in the EMU (see Figures 7.3 and 7.4). The financial system in the EMU was burdened by two factors. First, financial institutions investing in the US or even using their own special purpose vehicles to pool and sell credits, especially in Ireland with its lax regulations and low taxes, suffered heavy losses. Germany is also an example for this. Second, the bursting of the real estate bubbles and the subsequent sharp economic slump in 2009 led to an explosion of non-performing loans and rapid asset price deflation. Good examples are Spain, Greece and Ireland. After the collapse of Lehman Brothers the money market froze in the EMU. The EMU also had to contend with a very specific problem. In normal financial systems in developed countries during financial crises, typically only non-bank financial institutions are confronted with massive withdrawals of assets. The reason for this is that these institutions usually do not have sufficient insurance for their liabilities, whereas bank deposits are covered by deposit insurance schemes and banks, as a rule, are in turn rescued by governments and at the very least depositors are compensated. In the EMU there was no joint deposit insurance. It also remained unclear to what extent governments would be able to bail-out banks. One reason for such doubts was that governments in EMU member states had

lost their central banks, which could take over the function of lender of last resort, in a comprehensive way. Of course, it could be expected that the ECB, following Walter Bagehot (1873), would take over the function of lender of last resort for banks in liquidity problems. Solvency and liquidity problems in financial crises are difficult to distinguish.1 In a crisis falling asset prices and non-performing loans can quickly lead to insolvency (a situation with negative net wealth) whereas after the crisis asset prices may quickly rise and some overindebted firms or households may recover. Would the ECB help banks with solvency problems? And how strict would it be? The problem was exacerbated by the fact that banks held government securities or gave direct credits to their governments. This created a disastrous interaction between troubled banks and governments. The potential bankruptcy of banks increased the likelihood of the financing problems of governments and vice-versa. Against this background, it was by no means surprising that massive capital flight within the EMU set in. Capital flowed from financial institutions in the southern European euro countries and Ireland into the German banking system in particular, which was believed to be more stable. This could be done with very low transaction costs and no exchange-rate risk. As a result of these developments, even banks such as Spanish banks, which had invested little abroad, came under massive pressure. The subprime crisis in the US triggered the financial market crisis in Europe, but it was not responsible for it. The money market in the EMU froze, which also meant that entire countries were confronted with a sudden stop in capital inflows. There was a boom‒bust cycle within the eurozone, which is a particularly well-known phenomenon of emerging markets (see also Table 6.1). However, it is not typical for developed monetary unions. According to calculations by Philip Lane (2013), the sum of the annual inflows and outflows of international capital flows in the euro countries (including both intra-area flows and extraarea flows) in 2007 reached a value of over 40 per cent of GDP, starting from around 13 per cent in 2001. In 2008 capital flows then fell to below 10 per cent and in 2009 to below 5 per cent. This is a huge bust after a strong boom. Falling asset prices, bank credit rationing, change in sentiment among financial institutions, companies and households caused private demand for goods and services to fall. Production collapsed and unemployment rose sharply. The United States was affected by a shrinking real GDP earlier than the eurozone. In the US already in 2007, the growth rate decreased compared to the previous year and reached 1.9 per cent, followed by -0.4 per cent and -2.5 per cent in the following two years. The year 2010 saw a recovery with growth of 2.6 per cent. In the EMU, growth was still 3.1 per cent in 2007 and then it fell to 0.4 per cent. In 2009 real GDP decreased by 4.5 per cent. With 2 per cent in 2010, the recovery in the EMU was weaker than in the US. Germany was particularly affected with a negative GDP growth of -5.6 per cent in 2009. This reflects the extreme export dependency of the German economy (OECD 2020).

Figure 8.1 charts the total number of hours worked as an indicator of total employment. In the EMU the working volume of 2008 was only reached again in 2018, which goes to show the depth and length of the crisis after 2008. Looking at the development of total hours worked over the whole period, the US is in only a slightly better position than the EMU; however, after 2009 the US performed much better. Looking at employment volume Portugal and Greece had to accept big reductions and a weak recovery. Employment volume in Germany also did not increase much. After 2008 Ireland and Spain had huge drops in the number of hours worked but later experienced substantial recoveries.

Figure 8.1 Total hours worked in selected EMU countries and the US, 1998–2018 (index 1998 = 100) Source: US Bureau of Economic Analysis (2019); ECB Statistical Data Warehouse (2019).

Official unemployment rates in selected EMU countries are shown in Figure 8.2. Developments in the EMU countries are very different. Germany was able to bring unemployment rates down to relatively low levels (3.3 per cent in 2019). This was not only the result of an increasing working volume, but also by more part-time work and demographic factors. Greece and Spain suffered from very high unemployment rates and were not able to bring unemployment rates down to levels before the Great Recession until 2019. Ireland and Portugal managed to bring high unemployment rates down more quickly. In France and Italy unemployment rates remain at a relatively high level. Unemployment rates in the EMU in 2019 at 7.6 per cent were still slightly higher than they were in 2008 (7.5 per cent). In the US the unemployment rate increased from 4.6 per cent in 2007 to 9.6 per cent in 2010, but then dropped to 3.7 per cent by 2019 (OECD 2020).

Figure 8.2 Unemployment rates in selected EMU countries, 1999–2019 Source: OECD (2020), unemployment rate forecast (indicator).

After the Great Recession up until 2013, unemployment escalated in some EMU countries. In spite of the fact that employment is not an ECB target, the dramatic rise in unemployment in some member states necessarily affected monetary policy. In 2012 escalating crisis development and employment crises led to a radical change of monetary policy by the ECB.

The monetary policy response How did the ECB deal with the major challenge that unemployment rates posed for monetary policy? First of all, and surprisingly, the ECB raised the interest rate for main refinancing operations again from 4 per cent to 4.25 per cent on 9 June 2008, thus continuing the series of slow interest rate increases from mid-2003 (see Figure 7.11). At that time, Jean-Claude Trichet was president of the ECB having taken over in November 2003 from Wim Duisenberg. He justified the interest rate increase in this way: To sum up, a cross-check of the outcome of the economic analysis with that of the monetary analysis clearly confirms the assessment of increasing upside risks to price stability over the medium term … At the same time, the economic fundamentals of the euro area are sound, and incoming macroeconomic data continue to point to moderate ongoing real GDP growth … Against this background and in full accordance with our mandate, it is imperative that we prevent broadly based second-round effects and counteract the increasing risks to price stability. (ECB 2008a: para 14)

In fact, inflation in the eurozone approached the 4 per cent mark in July. However, this

was primarily due to rising oil prices. According to his comments, Trichet was concerned with preventing potential second-round effects. Since real wages decreased as a result of the oil price increase, he feared compensating rising nominal wages. Even if we are being generous, it is a surprise that with all its expert knowledge, the ECB did not foresee the deepest crisis of the postwar period and that Trichet was talking only a few weeks before the financial crisis hit Europe about “sound economic fundamentals” in the EMU. With even a superficial knowledge of events in the United States, which was already in crisis mode, he should have known better. From October 2008, however, interest rates for the main refinancing operations began to fall sharply, dropping to 1 per cent in May 2009 and remaining at this level until April 2011. In addition, from October 2008, the weekly main refinancing operations were carried out through a fixed-rate tender procedure with full allotment, which means that banks could refinance themselves to unlimited levels, as long as they had collateral to offer. They no longer had to use the marginal lending facility as an open discount window in the event of an extraordinarily high liquidity requirement. In order to create sufficient assets as collateral for banks, the ECB reduced the quality of the assets that could serve as collateral. Among other things, the standard of marketable and non-marketable assets which could serve as collateral was reduced from A- to BBB-. In addition, longer-term refinancing of three and six months was offered to banks (ECB 2008b). To date (early 2020), the ECB has maintained the fixedrate tender procedure with full allotment as well as longer-term refinancing. As a consequence, the banking system in the eurozone can very readily supply itself with central bank money. In July 2009, a covered bonds purchase programme (CBPP) of €60 billion was approved.2 Covered bonds were purchased by the ECB on the primary and secondary markets and held to maturity. This programme became necessary because the covered bond market, similar to the market for asset-backed securities in the US, had collapsed and dragged financial institutions into deeper financial problems. A second CBPP with a volume of €16.4 billion was launched in November 2011 and a third with a volume of €264 billion in October 2014 (ECB 2019a). In 2008, currency swaps played an important role in providing liquidity in the EMU. A currency swap is an agreement between two central banks to exchange currencies although a maximum volume is fixed. Traditionally, such swap agreements between central banks made foreign currencies available to a central bank whose currency was under devaluation pressure and wanted to intervene in the foreign exchange market. However, this has changed. Currency swaps now have the primary function of guaranteeing the liquidity of financial institutions with foreign currency liquidity problems during a crisis. In 2008 banks in the EMU experienced massive liquidity problems in US dollars following the collapse of Lehman Brothers. Banks had to meet short-term obligations in US dollars but were unable to

obtain dollars as the money market had dried up. Through currency swaps, the ECB was able to help the banks in the EMU without using its own US dollar reserves. The volume of swaps between the ECB and the Fed reached a maximum of $300 billion in 2008. The ESCB’s total foreign reserves in 2008 amounted to around $500 billion. The swap volume was therefore enormously high (ECB 2014). The Fed has thus assumed the function of lender of last resort not only domestically but also internationally. Figure 8.3 shows that during the crisis years of 2007 and 2008 the ECB massively increased its balance sheet volume, measured as a share of GDP. The ESCB’s balance sheet total increased from €1,500 billion in 2007 to €3,000 billion in 2012 and €4,600 billion in 2018 (ECB 2019d). This clearly illustrates the extent to which the financial system in the eurozone was disrupted by the financial market crisis and the extent to which the function of lender of last resort was needed in the eurozone. The Fed has altogether a smaller balance sheet volume measured as share of GDP than the ECB. This is probably due to the fact that the American financial system is much more capital market-oriented than the continental European system, which is more bank-based. The Fed recorded an increase in its balance sheet from $860 billion in 2007 to $2,830 billion in 2012, reaching a peak of around $4,500 billion between 2015 and 2017 (Fed 2019). Both central banks intervened until 2015 with a comparable volume. Based on the exchange rate at the beginning of November 2019, the ECB increased its balance sheet by only $371 billion more than the Fed. But taking into account that the EMU has a GDP of around two-thirds of US GDP it becomes clear that the ECB was forced to intervene to a much greater level than the Federal Reserve. Figure 8.3 makes also clear that after 2015 the Fed’s balance sheet as share of GDP dropped – a normalization that was not experienced in the EMU.

Figure 8.3 Balance sheets of ECB and Fed (% of domestic nominal GDP), 2003–19 Source: US Bureau of Economic Analysis (2019); Board of Governors of the Federal Reserve System (US) (2019); Eurostat (2019); ECB (2019).

After the outbreak of the financial market crisis the Fed lowered its refinancing rate significantly more than the ECB – although the slump in the eurozone was sharper than in the US (see Figure 7.11). Overall ECB’s monetary policy, at least in this phase, was less growthfriendly than the Fed’s. First, higher interest rates in 2008 to combat potential second-round effects of oil price increases were hostile to growth and unnecessary. It would have been appropriate for the ECB to have waited to see whether there were any relevant second-round effects and whether the ECB’s medium-term inflation target was at all threatened. Second, stronger and therefore bolder interest rate cuts by the ECB in 2008 would have helped to dampen the Great Recession.

Fiscal policy and bank bailouts In 2008 the financial market crisis hit the EMU. French President Nicolas Sarkozy invited the heads of government from Germany, the UK and Italy as well as the presidents of the ECB, the ECo and the president of the Eurogroup to Paris on 4 October 2008. Following recommendations of Dominique Strauss-Kahn, then head of the IMF, Sarkozy proposed setting up a common European fund to support financial institutions and stabilize financial markets. The idea was to follow the US, where on 3 October 2008 the Emergency Economic Stabilization Act established a fund of $700 billion managed by the US Treasury. “But Chancellor Merkel rejected this” (Stern 2008: para 1) and was strongly against a joint fund

for financial market stabilization (see also Polster 2019: 191). A moral hazard was perceived, according to which, joint actions of such a fund would promote irresponsible behaviour in the future, raising the expectations that financial institutions would be rescued from a crisis even by the other nations (Brunnermeier et al. 2016). Moral hazard considerations in an emergency situation leading to inaction will maximize costs. If a house burns and the fire brigade does not put out the fire because the owner was careless is not a good strategy. As joint action was rejected, particularly by Germany, every country in the eurozone had to bail-out its own financial institutions. To take Germany as an example, from 2008 to the end of 2013, the sum of measures taken to save the financial system amounted to €233.8 billion. This corresponded to more than 9 per cent of the German GDP in 2008. The reason for these costly state interventions was the investments of German financial institutions abroad, especially the US. In Germany itself, there was no relevant increase in bad loans. In other EMU countries this was a different matter. There financial institutions were stressed as a result of the bursting of the real estate bubble and over-indebtedness of the private sector (Detzer et al. 2017: 286; and Chapter 12). After all, Germany was financially in a position to restructure its own ailing banks. Due to the deep economic slump in all EMU countries, it might have been expected that there would be joint fiscal efforts by the member states of the EMU. But there was no cooperation in fiscal policy to stabilize aggregate demand. Nevertheless, 2008 and 2009 saw strong expansionary fiscal impulses, but planned and implemented by the individual member states. Figure 8.4 shows the structural budget balances in selected OECD countries as calculated by the IMF (see also Figure 7.9 for budget balances).3 It shows that the member countries of the EMU did indeed set fiscal impulses in 2008 and 2009. In Germany structural deficits were not very high. Overall fiscal impulses in the EMU were significantly lower than the US. In addition, those government expenditures that became necessary to stabilize the financial system and bail-out financial institutions did not directly influence aggregate demand. It is striking how quickly after the Great Recession most of the EMU countries went back to low structural deficits, even Germany showed structural surpluses. The fiscal consolidation in Greece was enormous with the corresponding catastrophic economic and social consequences as well as the political turbulences. Not to weaken the recovery or even trigger another recession the US reduced its structural deficits after 2009 much more slowly than the EMU.

Figure 8.4 General government structural budget balances (% of potential GDP) in selected EMU countries and the US, 1999–2019 Note: Cyclically adjusted fiscal balance as share of potential GDP. Source: IMF World Economic Outlook Database (2020).

In Germany the rapid downturn led to two economic stimulus packages. The first, in November 2008, provided for measures amounting to €12 billion and the second, in January 2009, almost €50 billion. The volume of both packages amounted to around 2.5 per cent of German GDP in 2009. If further smaller programmes are added to that total, the expansive impulse adds up to more than 3 per cent of GDP in 2008 (Detzer et al. 2017: 286f.). The German RWI-Leibniz Institute for Economic Research estimated that the larger package alone increased German GDP growth rate by 0.5 per cent in 2009 and 0.3 per cent in 2010 (Barabas et al. 2011). The economic stimulus packages were therefore quite effective. Even more expansionary fiscal policy would have been possible. In the US, for example, the American Recovery and Investment Act of 2009 had a volume of $787 billion. This corresponds to 5.5 per cent of the US GDP for 2009 (House of Representatives 2009). Figure 8.5 shows the development of public investment in per cent of gross capital formation. Public investment in 2008 and 2009 stabilized demand and production and it did not shrink in comparison to private investment. Stable high public investment stabilizes aggregate demand and reduces fluctuations in the business cycle. Also, with this indicator the US shows a stronger fiscal stance than the EMU. Germany performs very poorly in terms of public investment, which in relation to GDP has fallen from 2.5 per cent in 1995 to just over 2 per cent in 2019. In international comparisons, Germany ranks towards the lower range.

Figure 8.5

Public investment (% of total gross capital formation) in the EMU, US and Germany, 1999–2019

Note: Investment is typically in R&D, transport infrastructure, public buildings such as schools and hospitals and military expenditure (for civilian purposes, e.g., airfields, docks, roads, etc.). Source: OECD (2020), investment by sector (indicator).

Political leaders in Germany were sceptical about fiscal policy in their own country and the EMU as a whole. In 2009 a debt brake was adopted in parliament and even the German Constitution was amended to accommodate it. The debt brake limits over the business cycle new indebtedness of public households to almost zero and became a model for the EMU (see Chapters 9 and 11 for details). As a result of the debate over the debt brake, Germany did not extend or introduce new fiscal programmes to stimulate the economy.

Summary The ECB pursued its monetary policy goal of keeping inflation close but below 2 per cent. This explains why it raised interest rates further in mid-2008, even though the Great Recession had made itself known in the US and was just around the corner in the EMU. From autumn 2008, interest rates were then lowered by the ECB, but less drastically than by the Fed. The ECB nevertheless fulfilled its function as lender of last resort for the financial system. A joint restructuring of the financial system in the EMU failed, as did a common fiscal policy to combat the crisis ‒ essentially because of German resistance. Nevertheless, expansionary fiscal stimuli were provided in 2008 and above all in 2009. But already in 2009, under the leadership of Germany, a restrictive fiscal policy had been introduced in the

EMU.

9 MONETARY POLICY AND THE ESCALATION OF THE EURO CRISIS UNTIL 2012

Economic policy in the EMU during the Great Financial Crisis and the Great Recession were comparable with developments in other countries, for example the United States. But the further development in the EMU is very specific. It reflects the lack of central institutions in the EMU and the inability to find joint reactions to fight the crisis in the interest of the whole EMU. The fragility increased to such an extent that in 2012 there was the danger that the euro area would fall apart.

No comprehensive lender of last resort for public households Fresh adversity emerged in Europe at the end of 2009. Even during the upswing before the Great Recession, Greece had high budget deficits and a high national debt. In 2009, Greece’s budget deficit increased to almost 15 per cent and its public debt to around 130 per cent of GDP. From the end of 2009, doubts also arose about the accuracy of the statistical figures provided by Greece. Greece was only the tip of the iceberg, and other countries, especially Spain, Portugal and Ireland, were increasingly caught in a crisis maelstrom. These countries had demonstrated sound fiscal policy before the Great Recession, Spain and Ireland had even realized budget surpluses. The problem was a different one. The no-bail-out clause of the Maastricht Treaty hung like the sword of Damocles over the countries. They could not expect help from other EMU countries in case of financing problems of public households, and the ECB was strictly forbidden to help public households. In a self-fulfilling prophecy, doubts in financial markets as to whether public debt could be serviced led to liquidity problems in some of the member states of the EMU. Consequently, interest rates for credit to public households with potential finance problems started to escalate (see Figure 7.2). It was only a matter of time before governments themselves would become illiquid. They were indebted in their own currency, but the design of the EMU made them look as if they were indebted in foreign currency. In fact, they no longer had their own central bank, which in any normal nation state could have acted as lender of last resort through direct credit or indirectly through purchases of government

securities on secondary markets. There was also no fiscal centre in the euro area to assist. It was conceivable that Germany, as the largest EMU country, could have taken the coordinating lead in helping the governments in the crisis states. In return, certain economic policy measures could then have been demanded in order to correct undesirable developments, for example in Greece. Alternatively, following economic reason, one could have extended the mandate of the ECB so that it could have guaranteed the liquidity and solvency of public budgets in crisis states. None of this happened. In Germany, the debate in 2010 was influenced by the view that the Greeks were lazy and that it was up to them to sort out their own problems.1 It was not until the crisis worsened and the Greek government asked the Eurogroup for help shortly before its collapse in May 2010, that emergency loans of €110 billion were approved for Greece – €80 billion were bilateral loans from other EMU countries and €30 billion came from the IMF. In return for these loans, Greece had to comply with strict financial and economic policy measures, which lay entirely within the logic of an unfettered neoliberal policy. At the centre of the conditions were strict fiscal austerity, wage cuts, privatizations, deregulations and more flexible markets in almost every sector. An important goal of the conditions was the enforcement of internal devaluation, i.e. a real devaluation by lowering wages and price levels in Greece. A consortium, the Troika, was created in 2010 to negotiate and monitor the conditions dictated, consisting of the IMF, the ECo and the ECB. The IMF had become involved because Germany had turned to the IMF to ensure that the structural programmes would be implemented with great rigour. Especially by Germany, the ECo was not trusted to do this (Brunnermeier et al. 2016). At that time, the EMU did not have an appropriate common mechanism to help governments in crisis. The crisis countries were dependent on new loans to replace the old ones and to finance budget deficit. However, financial markets were unwilling to grant new loans or demand exorbitant interest rates. At the same time governments did not have any longer their own central banks which could act as lender of last resort. The crisis countries were therefore dependent on support from other EU or the EMU countries or the EU central budget to avoid the breakdown of government. After the breakdown of the Bretton Woods system the IMF came to help mainly developing countries which were indebted in foreign currency and could not service their foreign debt. But the situation in the EMU was different. The governments were indebted in their own currency, the euro, but at the same time they had lost a central bank that would guarantee that governments indebted in their own currency would not go bankrupt. In the end, a common mechanism became necessary because there was fierce controversy within the Community as to whether the ECB was allowed to provide financial security to the crisis countries without any ifs or buts. Financing of governments with liquidity (or given the construction of the EMU even solvency problems) via interventions in secondary markets or directly was excluded (see Chapter 4). “Hidden”

massive interventions on secondary markets in favour of the crisis countries and without fiscal conditions were blocked by Germany and its allies. The most obvious solution was to create a common fund that would support governments in the EMU in financial needs. Such a fund could then also dictate conditions under which help would be granted. From the beginning such a fund lacked the characteristics of a lender of last resort because a fund is always limited and cannot, in comparison to a central bank, guarantee the constant financial solvency of a government. A large common EMU or EU fund for exceptional challenges (one-sided burdens from migration processes, natural disasters, pandemics, etc.) makes sense, but not to act as a lender of last resort. Given the restriction for the ECB to act as lender of last resort and in spite of the limitations of a fund to do the same the EMU strategy to solve the financial problems of EMU governments was based on a common fund. An EU fund already existed, the European Financial Stabilization Mechanism (EFSM), established in 2005. The EFSM was an emergency fund with a maximum volume of €60 billion. Funds were raised on the financial markets and guaranteed by all EU countries and managed by the ECo (ECo 2020). The EFSM was much too small, and EU countries not in the EMU were not prepared to increase the fund. Therefore, in June 2010, the eurozone countries established a temporary intergovernmental organization, the European Financial Stability Facility (EFSF). The EFSF’s shareholders were the euro countries, which contributed in proportion to their shareholdings in the ECB. Each EMU country sends one member to the EFSF Governing Board. All important decisions must be taken unanimously. For decisions concerning the implementation of more technical issues, a two-thirds majority is sufficient. The EFSF was supposed to lend up to €440 billion. It borrows this money from the capital markets and the euro countries guarantee the debt in proportion to their share of the EFSF’s capital. A meeting between French President Nicolas Sarkozy and German Chancellor Angela Merkel in Deauville in October 2010 (Brunnermeier et al. 2016; Polster 2019) decided the way fiscal matters would be handled in the EMU. They agreed a common strategy in which the fiscal debt brake was included in national constitutions of the euro countries (Merkel’s request), but there were no automatic sanctions for breaches of fiscal rules and the ECo claims to power were restricted (Sarkozy’s wish). Of crucial importance, however, was the fact that Merkel was able to push her demand for adequate private sector participation in possible financial restructurings of public households in crisis. The no-bail-out idea became live again. Even bank deposits should not be taboo if banks got into trouble. These points were later confirmed by the European Council. The Franco-German proposal sent a fatal signal to financial markets that government bonds in the eurozone were no longer safe. The Franco-German proposal was mistaken, because those countries that had difficulties financing their budgets did not have a solvency problem, but a liquidity problem. In Spain,

for example, in 2010 the national debt was 67 per cent of GDP. But even countries with comparatively high government debt to GDP in 2010 (such as France with 101 per cent, Portugal 104 per cent, Italy 124 per cent and Greece 129 per cent) would not have had a problem under the conditions of a functioning currency area. For example, the public debt in the US in 2010 was 126 per cent and that of Japan even 208 per cent (OECD 2020). But neither the US nor Japan had solvency or liquidity problems. Governments that are indebted in their own currency cannot go bankrupt in their own currency. This is not to say that central bank financing of public budgets cannot have negative effects. If confidence in domestic currency is lost, it is exchanged for foreign currencies. If massive budget financing is provided by the central bank and monetary wealth created in domestic currency, a cumulative devaluation inflation spiral is triggered, which can lead to hyperinflation. An example of this is the hyperinflation in Germany of 1913 (Robinson 1938). But this was not the situation in the eurozone and there was no danger that it might develop. Instead, the lack of a lender of last resort resulted in an immense and unnecessary intensification of the crisis in the EMU (De Grauwe 2011). The German position was based on the logic of the Maastricht Treaty’s no-bail-out clause and that private capital markets would sanction governments. The threat of financial markets sanctions should discipline public households in such a way that they adhere to strict fiscal rules. The German government very consciously pursued a strategy that rejected a lender of last resort for public budgets. Without this facility the liquidity problems of public budgets in some EMU countries escalated and the crisis deepened. Yanis Varoufakis (2016), Greek finance minister for a short time in 2015, has made it very clear that the conditions for EFSF lending to Greece were to set an example for the future. The conditions were politically motivated. All other EMU countries should know that in the absence of fiscal discipline, brutal consequences should be expected. The austerity programme imposed on Greece proved to be economically wrong and socially irresponsible. In addition, it led to an escalation of the financial problems of public households across the EMU. At a joint meeting with ECOFIN in February 2010, US Treasury Secretary Timothy Geithner argued about Greece: “You can put your foot on the neck of those guys if that’s what you want to do. But you’ve got to make sure you send a countervailing signal of reassurance to Europe and the world that you are going to hold things together and not let it go” (Financial Times 2014). Geithner’s advice was not followed. As already mentioned, in the course of 2010 interest rates on government debt rose sharply not only in Greece but also in Italy, Spain, Portugal and Ireland (see Figure 7.2). At the same time, capital flight within the EMU into safe assets, namely German government bonds and bank deposits, increased. This must be seen as a consequence of the mishandling of the Greek crisis. This development shows once again that the financial markets did not trust the ECB to fulfil its role as a lender of last resort.

In November 2010, the Irish state needed support. An aid programme for Portugal was put together in May 2011. A second aid programme for Greece became necessary in July 2011. Included in this was a haircut, at the insistence of Germany and the Netherlands, in which the EFSF bought Greek government bonds from private creditors at a discount, costing private creditors €12.6 billion. In addition, short-term Greek government bonds were rescheduled into long-term ones. This measure cost private creditors €37 billion (Belke & Dreger 2011). In absolute terms this was not a large amount, but it signalled to financial markets that government debt in the EMU was not safe. In July 2012, major assistance was needed to stabilize the Spanish banking system. In December 2011, Cyprus received budget support. In the spring of 2013, Cyprus needed a further aid programme in which private creditors of uninsured deposits were involved in the restructuring of the banking system (ESM 2020). The adjustment measures for these countries were all negotiated by the Troika. Other countries, such as Italy, barely avoided an assistance programme and voluntarily followed Troika policies. Under the conditions, outlined above, that the ECB could not take over the function of a lender of last resort, the historical development showed that a temporary fund to support governments with financial problems in the EMU was insufficient. In September 2012, the eurozone countries therefore created the European Stability Mechanism (ESM), which can provide aid of up to €500 billion. As with the EFSF, the capital shares corresponded to the capital shares of the ECB. The ESM was established as a permanent fund, whereas the EFSF will be wound up after all aid loans have been repaid. The ESM Board of Governors consists of the ministers of finance of the EMU member states and is therefore identical in composition to ECOFIN. Each member country also appoints one member of the Board of Directors; the managing director of the Board of Directors is elected by the Board of Governors. Important decisions such as capital increases, granting of financial assistance and approval of memorandums of understanding must be made unanimously. Other decisions must be adopted with 80 per cent of the votes. Germany and France each have a veto right due to their high capital shares. The aid from EFSF and ESM taken together until the end of 2019 amounts to €6.3 billion for Cyprus, €203.5 billion for Greece, €18.45 billion for Ireland, €27.3 billion for Portugal and €41.3 billion for Spain (ESM 2020). The financial resources of the EFSF and ESM are far from sufficient to stabilize the EMU in the event of a crisis in a bigger EMU country. For example, at the end of 2019 Spain’s national debt alone was around €1,200 billion and Italy’s around €2,400 billion (OECD 2020). The ESM is simply not big enough to stabilize such countries. It cannot substitute a comprehensive lender of last resort. EFSF and ESM did not only suffer from the shortcoming that they could not take over the function as lender of last resort. The policy of conditionality was also misled. We do not argue for unconditional help in the medium or long run, but in the short run under certain

conditions it may be needed. However the conditions followed the logic that the burden of adjustment had to be borne exclusively by the crisis countries themselves. Crisis therapy included a harsh fiscal austerity policy and structural policies such as the deregulation of labour markets and a cut in the welfare state. Internal devaluation via reductions in the nominal wage was the key strategy to increase the competitiveness of the crisis countries. Given that current account surplus countries like Germany did not follow expansionary fiscal policy in the EMU, from 2010 fiscal policy became markedly restrictive (Bibow & Flassbeck 2018).

The ECB’s monetary policy In the phase following the Great Recession three monetary policy developments became of central importance: (1) the ECB’s limited efforts to act as a lender of last resort for public budgets; (2) the development of Target2-balances; and (3) the ECB’s interest rate policy.

Limited help for public households The EMU crisis came to a head in the spring of 2010, when the Greek state became de facto illiquid feeding doubts about the liquidity of other eurozone countries. On 10 May 2010, amidst an extremely critical financial situation for some public budgets in the euro area, the ECB decided to launch a securities markets programme (SMP). Under this programme, government securities in the secondary market were bought and held to maturity to help EMU governments in distress. It appeared as though the ECB would exceed its competences but as justification, the ECB pointed to the severe tensions in certain market segments that would hamper monetary policy. In the framework of the SMP the ECB bought larger stocks of government bonds from Greece, Italy, Spain, Portugal and Ireland in two phases. Between May and July, the ECB intervened with a volume of around €60 billion. During the euro crisis, which again worsened from August 2011 to January 2012, it made further purchases amounting to €140 billion. The money supply effects of these interventions were sterilized – money creation via other refinancing channels were accordingly reduced (ECB 2019a). In embryonic form, the ECB thus assumed the function of lender of last resort for public budgets. But the SMP was limited and also highly controversial within the ECB. This programme was heavily criticized, particularly by Germany. The president of the Bundesbank, Axel Weber, stated in 2010: “The purchase of government bonds entails considerable risks in terms of stability policy, and I therefore take a critical view of this part of the Governing Council’s decision even in this extraordinary situation” (Spiegel 2010: para 2). He resigned on 30 April 2011. Jürgen Stark, then chief economist of the ECB, resigned in

September 2012 in protest against the programme. He later criticized his former colleagues in the Governing Council for “stretching the ECB’s mandate to extremes”. There would be a danger that the central bank would increasingly “operate under fiscal dominance” because of its purchases on the bond market (Spiegel 2012: para 1f.). However, in view of the developing crisis, the ECB had no other choice. If government debt in the euro area had become non-performing on a large scale, banks, pension funds and insurance companies would have been dragged (deeper) into the abyss because they held large stocks of government securities. Then the crisis, via the domino effect, would have turned into a catastrophe.

Target2-balances Target2 (ECB 2008, 2019i) is a settlement system in the eurozone.2 At the close of each business day, monetary flows between banks are balanced. If, for example, the Spanish bank Banco Santander in Madrid has a net outflow vis-à-vis the German Postbank in Berlin, then the Spanish bank must settle the balance. If it can borrow the money on the money market, the ESCB is not affected. The situation is different if Banco Santander refinances itself with the Spanish central bank, Banco de España, and then transfers the newly created central bank money to the Postbank. In this transaction, the Banco de España books a debt to the Deutsche Bundesbank in its account with the ECB. As a counter entry, the Deutsche Bundesbank receives a credit balance vis-à-vis the Banco de España in its account at the ECB. These assets and liabilities created in EMU-member countries’ accounts at the ECB are Target2balances. These assets and liabilities arise only because the ECB is owned by the national central banks in the EU. If the ECB were the owner of central bank branches in the different euro area countries, which is the rule in nation states, the problem with debt and assets would not arise at all. The Target2-balances do not pose any risks in the eurozone. The liabilities built up in our example by the Spanish central bank never have to be repaid to the Bundesbank. There is no claim that the Bundesbank could sue for. Target2-balances are therefore an accounting effect resulting from the ownership structure of the ESCB. Since the creation of the euro until 2007 Target2-balances were negligible. Imbalances in payment flows within the EMU were settled via the money market, so that central banks were not involved to a great extent. This changed dramatically (see Figure 9.1) as the euro area money market collapsed in the course of the financial crisis and banks in crisis countries were cut off from the usual methods of refinancing themselves. As result Target2-balances started to increase and exploded after 2010. Germany in particular built up huge Target2balances, which reached almost €800 billion in 2012, over 30 per cent of Germany’s GDP of that year. But the Netherlands and Luxembourg as “safe havens” also had considerable

surpluses. The crisis countries Portugal, Ireland, Greece, Spain and also Italy in particular had high deficits.

Figure 9.1 Target2-balances of selected EMU countries, 2008–19 Source: ECB Statistical Data Warehouse (2019).

The net deficits in Target2-balances had four sources: 1.

A number of crisis countries had to finance their own current account deficits, some of which were high. Until 2012 these deficits were of low values or disappeared completely (see Figure 7.8) such that this source lost importance.

2.

In deficit countries banks had problems rescheduling their liabilities, for example issuing new bonds, because creditors did not renew loans that were due. The banks in the crisis countries therefore only had the option of refinancing themselves via their central banks.

3.

Capital flight increased substantially – as explained above – as wealth owners in crisis countries preferred to move their wealth to Germany and other countries as safe havens. It should not be forgotten that there was no common deposit insurance in the EMU and the crisis countries were restricted in how much help they could offer financial institutions. The Troika also was not helpful in creating confidence that wealth owners would not lose their assets in crisis countries. In 2010 when it was suggested that depositors at Greek banks should lose some of their deposits immediately, it prompted mass withdrawals and capital flight. For example, deposits in Greece had almost halved by the end of 2015 compared with the

beginning of 2010 (Statista 2019). 4.

Target2-balances reflect the massive purchases of securities by the ECB. They can arise when, for example, the Spanish or Italian central bank buys Spanish or Italian government securities from banks domiciled in the UK and these banks have an account with the Bundesbank. This reason only played an important role after 2012 (Deutsche Bundesbank 2017).

The Target2-balances are a thorn in the side of some German economists. For example, Hans-Werner Sinn (2018: 36), long-time president of the Ifo-Institute, argues: “A system that allows unlimited overdrafts cannot survive because it does not match the scarcity of resources in reality. It inevitably leads to overstretching claims until it breaks down for economic or political reasons.” Sinn rightly points out that the Target2-balances are a kind of unlimited overdraft for the financial system in crisis countries in the EMU, but without this financing the euro would no longer exist. Fortunately, the ECB has not followed the concerns of Sinn. It took over the function of a lender of last resort in a comprehensive way via the liquidity creation in the framework of Target2.

Interest rate policy In 2011, the ECB surprisingly initiated a more restrictive monetary policy stance, despite the crisis-ridden developments in the EMU. In April 2011, the interest rate for the main refinancing operations was raised from 1 to 1.25 per cent and in July to 1.5 per cent. In November 2011, the refinancing rate was lowered again to 1.25 per cent. In December it was cut back to 1 per cent (see Figure 7.11). ECB president Trichet’s statement on this policy was: Upward pressure on inflation, mainly from energy and commodity prices, is also still discernible in the earlier stages of the production process. It remains of paramount importance that the rise in HICP inflation does not translate into secondround effects in price and wage-setting behaviour and lead to broad-based inflationary pressures … In the Governing Council’s assessment, the risks to this economic outlook remain broadly balanced in an environment of elevated uncertainty. (ECB 2011: paras 7 & 8)

The Harmonised Index of Consumer Prices (HICP) had an inflation rate of just 2.7 per cent in June 2011. And despite the “elevated uncertainty” due to the critical developments in the southern European countries and a weak growth rate, the ECB raised interest rates. It did not even wait to see whether there were any second-round effects given the sharp rise in unemployment rates in the EMU. This interest rate policy, like the interest rate increases in 2008, was hostile to growth and employment and based on a complete misunderstanding of the macroeconomic constellation at the time.

The special case of Ireland Ireland is one of the countries that was hardest-hit by the financial crisis and has relied on EFSF assistance. This was partly due to the real estate bubble that had developed in Ireland by 2007 and partly to the liberal regulations governing the financial system, which made Ireland a centre of non-bank financial institutions. Looking at real GDP, Ireland has recovered well from the 2008/09 crisis and has been able to regain acceptable real GDP growth rates quickly. Development in Ireland has been substantially different compared with Greece, Spain, Portugal and Italy (see Figure 7.1). At first glance, Ireland appears to be a model for success, but it is a special case that is unsuitable for generalization (see Joebges 2017). Ireland has become a country of low corporate taxes and an active contributor to tax dumping in the EU. In particular, Ireland has become a tax haven for multinationals such as Apple, Amazon, eBay, Google, Facebook and Microsoft. They have located their European headquarters in Ireland or set up subsidiaries there, transferring the ownership of patents and licences to the subsidiaries and then renting the patents and licences to other EU countries. According to an OECD study (2010: 156), in Ireland foreign controlled affiliates of multinational companies had a share of domestic value added and turnover in manufacturing of about 80 per cent and employment of 47 per cent. Even in services more than 40 per cent of value added and turnover stem from foreign controlled affiliates that provide 28 per cent of employment in the sector. This sector accounted for over 90 per cent of Irish exports. This means that the development of Irish GDP is dependent on the growth dynamics of US and other multinational companies and their policy to shift profits to tax havens such as Ireland. For example, the real GDP growth of the Irish economy was 9.9 per cent between 2014 and 2019 (OECD 2020) but employment levels of 2007 were only attained again in 2018 (see Figure 8.1). The dominance of multinationals in the economy makes Ireland a special case.

Summary Overall, macroeconomic policy in the EMU after the Great Recession must be described as being extremely poor.3 The price of that ineffectiveness was high. Unlike the United States and the non-euro EU countries, the EMU slipped into a second recession in 2012 and 2013 (see Figure 7.1). A number of factors contributed to this development. First, fiscal policy switched too quickly to an austerity course after the Great Recession. Second, monetary policy became more restrictive in 2011. Third, there was no sufficient lender of last resort for public budgets. And fourth, the Troika, of which the ECB was a member, forced a completely asymmetric adjustment policy onto the crisis countries. In order not to be under the thumb of the Troika, countries like Italy changed over to the course of the

Troika on its own initiative. The result of this restrictive policy was a second recession and increasing budget deficits. The aim of reducing public debt as share of GDP could not be realized in the majority of EMU countries (see Figure 7.10). The policy of internal devaluation was catastrophic. Since exchange rates were no longer available, the Troika pushed for stagnating or even falling nominal wages. Indeed in Greece, Ireland, Portugal and Spain the Troika succeeded in reducing unit labour costs on the basis of falling or stagnating nominal wages (see Figures 7.5 and 7.6). A process of falling wages and prices is economically and politically extremely damaging for a country. In economic terms, falling costs and the associated fall in price levels increase the real debt of debtors in domestic currency. Irving Fisher (1933) had already stressed that a falling price level is a recipe for weakening the financial system and economic development in general. The Troika should have known that the strategy of internal devaluations perpetuates the problem on nonperforming loans in crisis countries. It should have come as no surprise to the ECB that the inflation target could not be achieved and that the inflation rate in the EMU dropped in 2013 to 1.4 per cent, to 0.4 per cent in 2014 and to 0.2 per cent in 2015 (OECD 2020). The danger of a deflationary development increased. One could have learned from the Japanese experience that stagnating and falling unit labour costs lead to deflation and a regime of stagnation (Herr 2015). The ECB should therefore have asked the Troika for an increase in wages in the EMU in line with the trend of productivity plus the target inflation rate. Lower wage increases in crisis countries like Greece, Spain or Portugal should have been compensated by higher wage increases in countries like Germany. Then the inflation rate would have approached the target inflation rate. Keynes (1925) flagellated the policy of lowering nominal wages in Britain after the country’s return to the Gold Standard in 1925 with an overvalued pound. According to Keynes, lowering nominal wages or incomes in a country is a kind of war. It is a hateful process because of the unequal effects of nominal income cuts on the stronger and weaker groups in a country and because of the economic and social losses generated. What happened in the EMU after the Great Recession was a completely asymmetric adjustment process that current account deficit countries and countries with financing problems in their public budgets had to endure. The surplus countries, especially Germany, could have supported a symmetrical adjustment process through expansionary fiscal policies and stronger nominal wage increases in their own countries. However, this did not happen. Thus Germany did not present itself as a “strong” hegemon in Europe, interested in the overall welfare of the EMU, but as a “weak” hegemon that paid attention to its short-term national advantage (Polster 2019). Germany as a consequence has damaged the European integration process.

10 THE ECB HOLDS THE EURO TOGETHER

In 2012 the monetary policy strategy changed fundamentally. The ECB was forced to take over the function as lender of last resort for public households, cut the refinancing rate to zero and start quantitative easing.

The ECB as lender of last resort for public budgets Mario Draghi became president of the ECB on 1 November 2011 during an acute economic situation and stayed in this position until 28 October 2019. At this point the EMU had slid into a second recession and the financing problems of public budgets in a number of EMU states had increased. This was very clearly demonstrated by the rising interest rates that governments in a number of countries had to pay. At the same time in most EMU countries unemployment became more severe. It was not a question of if but when the euro area would break apart. In this dramatic situation, the ECB overcame the EMU’s greatest shortcoming at the time. It assumed the function of lender of last resort for public households; it had no other choice. Without a lender of last resort for public budgets, the monetary union would hardly have survived. In a memorable speech on 26 July 2012, Draghi initiated the turnaround: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough” (ECB 2012: para 19). And he added: “Now to the extent that … the size of these sovereign premia hampers the functioning of the monetary policy transmission channel, they come within our mandate” (ECB 2012: para 27). Angela Merkel certainly supported Draghi’s course privately; at least there was no public criticism of it.1 In September 2012 as a result of the ECB’s change of strategy, outright monetary transactions (OMT) as a new monetary policy instrument were introduced. They allowed the unrestricted purchase of government bonds, so that state bankruptcy was ruled out. However, the promise of unlimited purchases of government securities was and is only valid if the country concerned falls under the EFSF/ESM rescue umbrella and follows the Troika’s conditions. Charles Wyplosz et al. (2012: 7) explained the logic of the OMT with great clarity: The OMT strategy fundamentally differs from the Securities Markets Programme (SMP) strategy. By committing to

guarantee a maximum spread (cap on spreads), or equivalently a minimum price (floor for bond prices), through unlimited purchases, the ECB now deals with debt stocks. The SMP strategy, however, was in the nature of acting on flows because it was explicitly temporary and limited in size. This is why it failed.

The announcement that the ECB was assuming the function of lender of last resort for EMU governments was a credible signal for financial markets. The interest rate differentials within the eurozone immediately declined significantly (see Figure 7.2) and the threat of the alleged sovereign debt crisis came to an end. As a result, the OMT programme has to date never been called upon. The EMU could have avoided high economic and social costs, if the ECB had introduced an OTM programme in early 2010 or if it had been part of the ECB’s constitution.

Zero interest rates and quantitative easing After increasing the interest rate in July 2011, a correction was made in November 2011, shortly after Draghi’s appointment. The interest rate for the main refinancing operation was cut from 1.5 to 1.25 per cent and then again to 1 per cent in December 2011. This was followed by a series of further reductions until the interest rate for the main refinancing operation fell to 0 per cent by March 2016. It has remained at this level until today (early 2020). This demonstrates in itself that economic development in the eurozone has been unsatisfactory during this phase – GDP growth has been low and the inflation rate is below the ECB’s target (see Figures 7.1 and 7.7). The interest rate for the deposit facility had been reduced to zero in 2012 and it became negative at -0.1 per cent in 2014. A further adjustment to -0.5 per cent took place in September 2019. Banks therefore have to pay interest if they deposit financial assets with the central bank. Because of the absence of quantitative limitation in the main refinancing operations, the marginal lending facility lost its relevance; the money market interest rate (EONIA) fell close to the deposit facility and became negative (see Figure 6.2). As a result of the ECB policy interest rates for private depositors at banks fell to zero as well. In mid-2016, for example, German two-year bond yields became zero or negative and have remained so until today (early 2020). Even for five-year or ten-year German bonds interest rates have been negative for some time. In countries like Austria, the Netherlands and France interest rates are only slightly higher (Trading Economics 2020). For governments and debtors in general low interest rates reduced costs. Also asset prices were stabilized by the low interest rates. Share prices collapsed during the financial crisis and Great Recession dramatically from historical very high levels. But in the EMU as a whole in 2019 share prices almost realized the same level as in 2007. Also in countries hit by deep crises, for example Italy and Portugal, share prices increased sharply after the collapse during the Great Recession. In Baltic states share prices increased to record levels. In most countries share

price development did not reflect economic performance or realist economic perspectives (OECD 2020). Especially in Germany there developed the danger of a real estate bubble (see Figures 7.3 and 7.4). For pension funds, (life) insurance companies, or banks with long-term fixed interest rates in, for example, saving plans, the low interest rates became a heavy burden. Private wealth owners realize no returns, unless they make higher risk investments. What is the reason for such an aggressive expansionary interest rate policy that without a doubt carries these negative side effects? The simple answer is that in the EMU, with the outbreak of the financial market crisis, credit expansion to the private sector came to a standstill and has yet to recover (see Figure 10.1). In stark contrast to this, the United States was able to revive credit expansion to the private sector and succeeded in returning to “normal” conditions on credit markets. The policy of low interest rates has undoubtedly stabilized economic development in the EMU as interest payments of indebted companies, households and governments have fallen significantly. But the willingness to take or give credit to invest remained poor. This again proves that low interest rates alone cannot trigger an expansion when confidence is low (Keynes 1936). Gross capital formation in the EMU reached a value of €2,406 billion (at current prices) in 2008, and then fell to €1,942 billion in 2013, before rising again slightly to €2,196 billion by 2018. Private investment, therefore, recovered only slightly after 2013 but did not return to the levels of 2008. In 2019 the global economy, even before the Covid-19 crisis, cooled with a growth rate and inflation rate in the eurozone of around 1.1 per cent (Eurostat 2020).

Figure 10.1 Credit to the private sector in the EMU (€ billion) and the US ($ billion), 1996–2019 Source: ECB Statistical Data Warehouse (2020); Federal Reserve Bank of the USA (2020).

The ECB attempted to overcome the continuing investment slump in the EMU with various unconventional policy measures. It wanted to encourage banks to lend and

companies to borrow. To this end, the ECB not only dictated the short-term interest rates but also wanted to bring down the long-term rates. The targeted longer-term refinancing operations (TLTROs) were launched in September 2014 and were initially planned to run for two years in several rounds. The purpose of this programme was to stimulate lending to companies and also households with the exception of households’ real estate investment. The ECB (2019b: para 1) wrote “By offering banks long-term funding at attractive conditions they preserve favourable borrowing conditions for banks and stimulate bank lending to the real economy”. With appropriate lending to the real economy, banks were able to refinance themselves with the ECB at a fixed interest rate of up to four years at the interest rate for the main refinancing operations of 0.1 per cent. The programme was renewed in March 2016. In the case of TLTRO II the interest rate to be paid by the banks now corresponded to that of the deposit facility. As the latter was negative, banks thus received interest from the ECB if they granted loans to the real economy and refinanced themselves through the ECB. TLTRO III started in September 2019 with an approved maximum refinancing term of three years. The interest rate for this programme was now 0.5 per cent below the interest rate of the deposit facility, which in March 2019 was -0.5 per cent. This meant that banks received interest payments of up to 1 per cent if they financed the private sector (ECB 2019b). The core element of the ECB’s unconventional monetary policy, also called quantitative easing, was and is the asset purchase programme (APP), which was implemented from 2015 onwards. Although covered bonds had previously been purchased on the secondary market, these interventions were relatively small. In the APP the ECB acquired various assets such as government bonds, corporate bonds or collateralized credits. This has massively increased liquidity in the financial system. Through this mechanism, the ECB seeks to stimulate credit expansion and growth in the real economy. The APP “will also help businesses across Europe to enjoy better access to credit, boost investment, create jobs and thus support overall economic growth, which is a precondition for inflation to return to and stabilise at levels close to 2 per cent” (ECB 2015: para 4). The monthly net purchases of securities under the APP are shown in Table 10.1. Table 10.1 The asset purchase programme of the ECB, monthly net purchases Mar 2015–Mar 2016 €60 billion Apr 2016–Mar 2017 €80 billion Apr–Dec 2017 €60 billion Jan–Sep 2018 €30 billion Oct–Dec 2018 €15 billion Jan–Oct 2019 €0 billion Nov 2019– €20 billion Source: ECB (2019a).

The APP is divided into various sub-programmes. Table 10.2 shows the stocks of the various programmes on the ECB’s balance sheet in October 2019. The significant rebound in Target2 balances after 2014 (see Figure 9.1) is linked to the APP because Target2 balances do not reflect, as before, large current account balances or capital flight from crisis countries. Instead, as mentioned above, they increase, when, for example, European central banks buy government bonds from foreign banks and these banks have an account with another central bank within the EMU. Table 10.2 The asset purchase programme stocks, October 2019 (in € million) Programme Stocks Public sector purchase programme (PSPP) 2,082,106 Covered bond purchase programme III (CBPPIII) 260,755 Corporate sector purchase programme (CSPP) 176,937 Asset-backed securities purchase programme (ABSPP) 26,925 Overall asset purchase programme (APP) 2,546,883 Source: ECB (2019a).

About three quarters of the interventions are related to the public sector purchase programme (PSPP). Under this programme the ECB bought bonds on the secondary market from euro area central governments, selected European institutions and international organizations and multilateral development banks. In December 2018 securities issued by international organizations and multilateral development banks accounted for around 10 per cent. This was planned to also remain so in the future. From December 2015, bonds issued by regional and local authorities could also be bought. For the purchases, a fixed allocation key was defined for the individual euro countries, based on their share of the ECB’s capital. In quantitative terms, the share of German securities in this programme was therefore the largest. The programme undoubtedly helped to finance public budgets in crisis states. To support the corporate sector in 2016 the ECB started with the corporate sector purchasing programme (CSPP) as part of the APP. The CSPP was focused on buying securities issued by corporations, which the ECB can buy on secondary and primary markets. The securities must have a term of at least six months and no more than 31 years. In buying corporate debt securities, the ECB does not pursue any particular industrial policy objectives, but it does also buy bonds to finance projects and companies which support ecological transformation (green bonds). The asset-backed securities purchase programme (ABSPP) was launched in November 2014. Its purpose was to buy asset-backed securities on the secondary or primary market. As with the CSPP, this intervention was intended to strengthen the liquidity of securities markets and the refinancing possibilities of banks and was integrated into the APP. Net purchases of securities were reduced from April 2017 onwards and bottomed out in

January 2019 (see Table 10.1). In November 2019 purchases resumed as economic development in the EMU slowed and the low inflation rate persisted. This decision to spend €20 billion per month was highly controversial in the Governing Council of the ECB. Sabine Lautenschlaeger, German member of the ECB’s Board of Directors and Governing Board, resigned in protest against this decision. Reuters (2019: para 1ff.) commented: ECB hawk Lautenschlaeger resigns amid policy backlash … The announcement comes amid unprecedented discord at the top of the ECB, where a third of policymakers at the Sept. 12 meeting dissented with a decision to resume bond purchases in a bid to revive inflation in the euro area. Among them was the Bundesbank’s own President, Jens Weidmann, along with governors from France and the Netherlands … Frustration at the central bank’s easy-money policy of sub-zero rates and massive bond buys is running high in Germany, with tabloid Bild depicting ECB President Mario Draghi as a vampire sucking off Germans’ savings.

Fiscal policy, current account and wage development Fiscal policy has not been actively deployed since 2012. Despite the recession in the EMU in 2012 and 2013, budget deficits as share of GDP were significantly reduced from 2012 onwards (see Figure 7.9). As growth was weak, most EMU countries were still unable to reduce their public debt to GDP (see Figure 7.10). The structural budget deficit in the EMU was almost balanced; Germany and Greece had high structural surpluses (Figure 8.4). Fiscal policy has not contributed to growth in the eurozone. There was no productive interaction between monetary and fiscal policy in the EMU, rather the ECB for years had been forced to implement an extremely expansive and unconventional monetary policy. Instead of supporting monetary policy, the EMU/EU expanded its overall restrictive fiscal framework and other macroeconomic control mechanisms, particularly in response to pressure from Germany. In Chapter 11, we shall discuss these reforms briefly. Germany was historically the biggest critic of the expansionary monetary policy.2 From its launch until 2011, the eurozone managed to maintain an almost balanced current account. From 2012, the EMU started building high current account surpluses, reaching 3 per cent of the EMU’s GDP in 2015–19. These surpluses stabilized demand in the EMU area but were disruptive for the world economy. Nominal unit labour costs in a number of EMU countries after the Great Recession followed a long period of stagnation and even decline. In Germany, after the Great Recession unit labour costs began to rise, but the adjustment so far (first quarter 2020) is too small to compensate for the long period of unit labour cost stagnation in Germany before the Great Recession (see Figure 7.6).

Comparison with the Fed’s monetary policy From 2007, the Fed intervened in financial markets to roughly the same extent as the ECB.

To give a brief overview, we will summarize here the three groups of interventions that were implemented (Fed 2019a). The first group consisted of programmes for the provision of short-term liquidity to banks and other financial institutions. This was done by refinancing through the usual discount window. In addition, special programmes in this area were introduced: the term auction facility started in December 2007 and the primary dealer credit facility and term securities lending facility both introduced in March 2008. It should not be forgotten that the Fed, as an international lender of last resort, also carried out currency swaps with other central banks. A second group of programmes included direct lending to institutions in key credit markets. These include the asset-backed commercial paper money market mutual fund liquidity facility (September 2008), the commercial paper funding facility and money market investor funding facility (October 2008) and the term asset-backed securities loan facility (March 2009). It is worth noting that the Fed’s lender of last resort function is very broadly interpreted and goes far beyond the banking system. In the final group of programmes, long-term debt securities are purchased in secondary markets as part of quantitative easing in order to increase liquidity in the financial system and lower long-term interest rates. In September 2012, for example, the Fed began the net purchase of mortgage-backed securities amounting to $40 billion per month. Starting in January 2013, the Fed increased its holdings of longer-term US Treasury securities by $45 billion per month. There are some key differences between the interventions of the Fed and the ECB. The Fed has bought many more toxic securities than the ECB. In this way, the Fed actively helped to clean the balance sheets of financial institutions from doubtful claims much more than the ECB did. Also, despite a relatively high level of government debt to GDP in the US, there was never any doubt about the liquidity and solvency of public budgets. There was an implicit guarantee from the Fed for public debt at all times. All the programmes of the first and second groups listed above have now expired. With quantitative easing, monthly purchases were reduced from January 2014 and concluded in October 2014. This brought the Fed’s balance sheet growth to an end. From the end of 2015, the federal funds rate was gradually increased and reached 2.5 per cent at the beginning of 2019. Compared to the ECB, the Fed has succeeded in exiting hyper-expansive monetary policy, as economic development was much more positive in the US than it has been in the EMU. This also allowed the Fed to lower the federal funds rate to below 2 per cent in autumn 2019 as part of monetary policy.

Summary Contrary to expectations, the ECB, originally conceived as a technocratic supranational

institution, has become a highly political central bank. The member states’ renunciation of national sovereignty in monetary policy, which was considered by many as a neoliberal triumph, has not quite worked as expected. Circumstances forced the ECB to become a lender of last resort for public households in 2012 and to follow hyper-expansionary monetary policy. Without the ECB, the euro would not have survived. However, at second glance the ECB’s outstanding role in preserving the euro is not so surprising. It is the only truly powerful supranational institution in the EMU and the only one that, based on its function, has to represent the overall interest of the EMU. The fact that the ECB has no supranational partner in fiscal policy has proved a major flaw in the EMU construct. Fiscal policy to stabilize the EMU ceased in 2010. The fiscal policy implemented in the EMU since then was responsible for the second recession in 2012– 13, which countries outside the EMU did not experience. An EMU-wide functional fiscal policy would have been conceivable under Germany’s leadership or even with its consent, but Germany was obsessed with the idea of a public debt brake and even neglected public investment in Germany as a result. Mario Draghi, in his farewell remarks in October 2019, was very clear in his demand for the EU to create a strong fiscal centre: In our monetary union, national policies play the main role in fiscal stabilization – much more so than state-level policies in the US. But national policies cannot always guarantee the right fiscal stance for the euro area as a whole. Coordinating decentralised fiscal policies is inherently complex. And uncoordinated policies are not enough … This is why we need a euro area fiscal capacity of adequate size and design: large enough to stabilise the monetary union, but designed not to create excessive moral hazard. (ECB 2019c: para 23)

Germany seems to want to transform the entire EMU into a mercantilist model, following its example, with high export surpluses as the central growth engine. The high current account surpluses of the EMU after 2005 support this. But the EMU is too big for such a strategy to succeed and other global players will not accept it in the long run. Donald Trump’s approach and policy towards the EU clearly demonstrates this. Due to the shortcomings in macroeconomic management in the EMU, the ECB has been unable, in comparison to the Fed, to abandon its zero interest rate policy and start to reduce its balance sheet total. On the contrary, the ECB restarted its net security purchase programme in 2019. An overall assessment of the ECB’s monetary policy after the Great Recession was set out in the “Memorandum on ECB Monetary Policy” (October 2019) signed by Herve Hannoun (former first deputy governor of the Bank of France), Otmar Issing (former member of the ECB’s Executive Board), Klaus Liebscher (former governor of the Austrian central bank), Helmut Schlesinger (former president of Germany’s Bundesbank), Juergen Stark (former member of the ECB’s Executive Board) and Nout Wellink (former governor of the Dutch central bank). It makes the following points: first, the ECB should accept that the inflation

rate has been below and not close to 2 per cent for years; a danger of deflation does not exist. Second, quantitative easing has ceased to have positive effects and “the ECB has already entered the territory of monetary financing of government spending, which is strictly prohibited by the Treaty” (Bloomberg 2019: para 6). Third, the period of very low interest rates led to a “zombification” of the economy: firms and financial institutions, which would normally have become bankrupt in a climate of higher interest rates, survived and this has reduced productivity increases. Fourth, there are massive redistribution effects: “The redistribution effects in favour of owners of real assets create serious social tensions” (Bloomberg 2019: para 7). And finally, financial investors act in a more risky way to stabilize their returns: “The search for yield boosts artificially the price of assets to a level that ultimately threatens to result in an abrupt market correction or even in a deep crisis” (Bloomberg 2019: para 7). In our opinion, some of these arguments are valid, others are not. It definitely would be a mistake to accept lower inflation rates. The Troika’s wage policy, based on the idea of internal devaluations and the lack of wage coordination in the EMU since 2009, led to an insufficient increase in the level of unit labour costs. The consequence was an inflation rate that was too low, so that the ECB had to fight against the danger of deflation. There is the danger that the EMU suffers from a Japanese scenario. The ECB should actively demand a higher increase of the nominal wage level in the EMU. The argument that a consequence of quantitative easing is to finance indirectly public budget deficit might be correct. When the ECB supports fiscal policy in periods of insufficient growth, this should not be criticized. The ECB should push for a more expansionary fiscal policy, for example for a green deal to stimulate public investment. But it has to be seen that the very expansionary monetary policy may have lost its stimulation effects for banks. The negative interest rate for central bank money reserves held by banks – interest rate on deposit facility – introduced by the ECB, in particular, acts like a tax and weakens the balance sheet of banks. As others have pointed out, “this balance-sheet effect could outweigh the incentive effect” (Stiglitz 2020: 80). The zombification argument is not compelling. In competitive markets competition pushes out unproductive and loss-making firms. It is the increasing concentration of market power that creates the danger of zombification of the economy, not low interest rates. Low interest rates increase productivity; a zero interest rate leads to the most optimal time span for the production of a good. A positive interest rate reduces this time span (Keynes 1936: 216). A low level of interest rates has without doubt deep distributional effects. Keynes (1936: 221, 376) believed in the “euthanasia of the rentier” in mature capitalist societies because he thought that the scarcity argument, which allows income without work in case of real estate, would disappear in the case of reproducible capital goods. In a world of pure competition and zero interest rates, profits would tend to zero as well and only excellent entrepreneurship

would be remunerated with profits. There are two distributional problems linked to the current very low interest rates. First, owners of real estate are indeed privileged. As the price of real estate, as in a metropolitan city, has no natural price anchor, just as for a Rembrandt painting, real estate prices and rents can explode, with very negative effects for large sections of society. Second, the concentration of markets, including branding and artificial product differentiation in today’s capitalism has reached a level that allows very high rent-seeking of firms (Stiglitz 2012; Herr 2019). Owners of monetary wealth may see themselves disadvantaged vis-à-vis owners of firms. Periods of low interest rates can under these circumstances lead to dangerous bubbles and abrupt market correction or even to a deep crisis, as is written in the Memorandum. Monetary policy has fuelled renewed asset market inflations in stock markets and partly real estate markets via the zero interest rate policy and the massive purchases of securities. Private and institutional investors are incentivized to invest in risky assets to stabilize their returns. And they have done so. The risks in financial markets have increased significantly again (see Chapter 13). At the same time the power of the ECB to fight new crises has decreased. The hyper-expansionary monetary policy of the ECB has kept the euro together and stabilized the poorly performing eurozone. There were substantial negative side effects of this policy. A constellation of low interest rates is desirable and also possible, but to achieve this aim permanently the general character of our current type of capitalism has to be changed. This has not happened and has not been the aim of the ECB. The ECB must be seen to act in the overall interest of the EMU in an environment in which there is a lack of EMU institutions and EMU countries to follow common interests.

11 THE FISCAL POLICY FRAMEWORK IN THE EMU: NO PARTNER FOR THE ECB

The Stability and Growth Pact (SGP) adopted shortly before the start of monetary union establishes binding fiscal rules for the participating countries. The aim of the SGP was and still is to put fiscal policy in a straitjacket assigning it an overall minor role in the EMU. To this end, the aim of the SGP from the beginning was to achieve a public budget that tends to be balanced over the business cycle (see Chapter 3). In the first phase of the EMU many countries violated the SGP terms, in some cases by a long way (see Figures 7.9 and 7.10). Even the larger member states such as Germany and France had public budget deficits higher than 3 per cent of GDP, thereby failing to comply with a core rule of the SGP. In response, the ECo tried to enforce appropriate sanctions against the delinquent countries. However, the ECo was called off by ECOFIN, resulting in no sanctions being imposed. On the contrary, in 2005 the rules of the covenant were softened considerably (see Chapter 7 for details). For the advocates of the SGP these developments were a nightmare. The former German finance minister, Theo Waigel, under whose eyes the pact had been agreed, criticized the 2005 reforms in no uncertain terms: “The Kohl government enforced the Stability Pact in 1997 against fierce resistance. That Germany then failed to meet the criteria of the Stability Pact in 2002 and 2003 and instead of immediately correcting its sins, amended the Pact together with France was a mortal sin. In this way, rules and standards lose trust” (Waigel 2015: para 9). His position was shared by the Deutsche Bundesbank, among others, and reflected the attitude of parts of the political and scientific elite in Germany (Euractiv 2006). The onset of the financial market crisis and the subsequent Great Recession led to a sharp rise in budget deficits across Europe. An expansive fiscal policy was implemented to combat a sharp downturn in all EMU-countries, however, it lacked coordination. As early as 2009, Germany decided to end expansionary fiscal policy and reduce its budget deficits. In 2009, the debt brake was adopted by the German parliament with the aim of considerably restricting the scope for fiscal policy. No new fiscal stimulus was provided in 2010, and the German budget deficit had already fallen to 1 per cent of GDP in 2011 and to zero in 2012. From 2012 on Germany realized structural budget surpluses (see Figure 7.9). The massive problems some countries faced in 2010 (beginning with the Greek sovereign debt crisis) in financing their public budgets and rescheduling public debt was seized on by

Germany in particular to reform the SGP further and correct the “mortal sin” of having previously relaxed it. Germany, supported by some smaller central and northern European EMU member states, used its position as the strongest economy in the EMU and the weakness of mainly southern EMU member states to impose restrictive fiscal policy and new fiscal rules for the EMU as a whole. The new fiscal rules meant countries, which were not under the thumb of the Troika, still had to follow restrictive fiscal policy with the end result of a second recession.

The German debt brake Germany tightened its fiscal rules in 2009. Ironically, this policy change was introduced just when the necessity and effectiveness of fiscal stabilization had become more than clear. The debt brake in Germany assumed a constitutional status, which means it only can be changed when two-thirds of the German parliament and two-thirds of the second German chamber, the Bundesrat agree. At the heart of the debt brake, which follows the philosophy of a strict SGP, is the reduction of structural budget deficits close to zero. Over the business cycle, budget deficits should tend towards zero. The German Federal Ministry of Finance summarizes the debt brake: The principle of a (structurally) balanced budget, which is jointly established for the Federation and the States in Article 109 of the Constitution, replaces the basic idea of the golden rule of the old Article 115 of the Constitution. The reform of the debt rules thus follows the philosophy of the European Stability and Growth Pact, according to which the budgets of the member states should be ‘close to balance or in surplus’. (BMF 2015: 6)

Thus, contrary to the golden rule of fiscal policy, in the long term, even public investments are no longer permitted to be financed by loans. The details of the German debt brake stipulate that the federal states can no longer create structural deficits. The federal government is permitted to run structural deficits to a maximum of 0.35 per cent of GDP. Small cyclical movements of budget balances are permitted, so that higher deficits can be realized in downturns that have to be compensated by budget surpluses in upswings. Exceptions are only possible in the event of natural disasters or exceptional emergencies, such as a deep financial crisis or severe recession. In which case, they must be accepted by a simple majority in the German parliament. At the same time, repayment arrangements must be fixed to guarantee that, in case of exceptions, in the long term public debt to GDP does not increase. For the federal government, the debt brake had to be applied from 2016, for the federal states from 2020. This law was the inspiration behind the European Fiscal Compact, enforced in 2013. The empirical application of the debt brake is complicated and controversial. It stands and falls with a convincing separation of cyclical (meaning actual) and structural variables. The

important variable is the structural budget balances as a percentage of a hypothetical average GDP over the business cycle. The hypothetical GDP expresses potential output. If the structural budget deficit in relation to the hypothetical GDP is more than 0.35 per cent, then, according to the rules of the debt brake, measures must be taken to reduce the budget deficit through expenditure cuts or tax increases. In any actual economic situation, a hypothetical structural budget balance in relation to a hypothetical GDP can be calculated to judge whether the actual budget balance is in line with the rules of the debt brake or not. How is the hypothetical GDP which reflects the production potential calculated? One method is to use a macroeconomic production function with a macroeconomic real capital stock, a macroeconomic labour force and a certain development of productivity.1 Theoretically, the correct measure of the real capital stock in a production function is a problem that cannot be solved. The relative prices of capital goods change according to many factors such as technological development, variation in the functional distribution of income and wage structure, exchange rate movements, or tax system adjustments. In addition, only a nominal capital stock can be directly statistically measured. To calculate a real capital stock a deflator has to be used; this is very imprecise. The calculation of macroeconomic depreciations is equally challenging, because in the production function only the capital stock that actually exists can be used. Thus, as the calculation of the hypothetical GDP via a production function is difficult and imprecise, past developments are extrapolated into the future. As a result, economic policy and thus fiscal policy itself can influence the calculated hypothetical GDP. For example, expansive fiscal policy in the case of underutilized capacities increases real GDP and employment. GDP then grows more strongly in the short and long term in comparison to a situation without expansive fiscal policy. If fiscal policy directly or even indirectly triggers public or private investment, the production potential is altered by the change in the capital stock. Therefore, the potential GDP also depends on fiscal policy (and monetary or other macroeconomic policies). A restrictive fiscal policy regime produces a low actual and consequently low hypothetical GDP, signalling that fiscal policy should be even more restrictive as the growth of the hypothetical GDP is low. Furthermore, there is no generally accepted method for the “smoothing” of historical data; there is always a high degree of arbitrariness.2 The problem we have here is that the long-term trend is the result of a sequence of shortterm developments that are also influenced by fiscal policy and not the result of factors, which are independent of short-term policies and aggregate demand. Consequently, it is no longer possible to distinguish between structural and cyclical components of growth. In view of the numerous weaknesses of this concept, it is not surprising that estimates of potential real GDP have had to be repeatedly revised in retrospect (Jarocinski & Lenza 2016; Truger 2014).

The calculation of the structural budget balance, the budget balance of the production potential, is controversial as well. To calculate it the cyclical elasticity of government revenues and expenditures have to be known but, these are not stable over time. They are influenced by changes in social policy, the functional distribution of income or the technological structure of the economy. Elasticities from past developments can be misleading. If these complicated calculations were merely empirical games played by idiosyncratic economists with no practical relevance, one could sit back and relax. In reality, however, they restrict the state’s scope for fiscal action on the basis of highly questionable calculations, which have direct consequences for the development of economies and the living conditions of millions of people. A long-term annual increase of the federal government’s net debt of no more than 0.35 per cent of GDP and an absence of debt in federal states would lead to a very low public debt ratio in Germany in the long run. If we assume a (permanent) deficit ratio of 0.35 per cent for the federal government, no deficits for the states, economic growth of real GDP of 1 per cent and an inflation rate of 2 per cent, then Germany’s public debt ratio would fall to 11.7 per cent of GDP over the long term (Holtfrerich et al. 2015: 40). Such a low debt ratio makes no sense. It is damaging for the needs of the private sector, which wants secure assets to keep monetary wealth in. Why shouldn’t the state, like private companies, at least partially finance its investment activities through loans? Public investment secures the economic future of a country and should be supported by credit. The golden rule of fiscal policy was a sensible rule that should be considered as a long-term guideline for fiscal policy. If an even more far-reaching fiscal rule is desirable, then a maximum public debt ratio could be specified, which, it should be pointed out, cannot be determined scientifically but only politically. The abolition of the debt brake would be highly relevant for Germany, since public investment as a share of GDP has fallen from a level of 2.5 per cent to just over 2 per cent since 1995. Internationally, Germany is in the lower range, far behind the United States for example (see Figure 8.5). In the interest of future generations, public investment in Germany needs to be significantly increased. Beyond the empirical and methodological problems in determining structural budget balances, laws such as the SGP and the debt brake run the risk of promoting or even forcing pro-cyclical behaviour (see the debate about this in Chapter 3).

European Semester: reform of the SGP, Sixpack, Fiscal Compact and Twopack It was obvious to policymakers that a repeat of the developments in Europe that led to the

crisis of 2008/09 should be prevented. A whole raft of regulations was adopted and implemented in order to increase coordination of economic policies across EU countries and especially EMU countries. Most of the rules focused on fiscal policy, some went further. The new regulations were massively influenced by Germany for whom fiscal discipline was a top priority. The SGP was first reformed as part of the Sixpack, and then followed by the Fiscal Compact and the Twopack. A new process called the “European Semester” was introduced to coordinate and monitor the economic policies of the EU member states. The European Semester is therefore not an independent regulation, but implements the Sixpack, the Fiscal Compact and the Twopack. We shall briefly outline the individual legislative measures.

Sixpack A stricter SGP seemed inevitable after its relaxation in 2005, especially for Germany and its neoliberal allies in the EU. As early as December 2011, six relevant legislative measures came into force. Four of them tightened the SGP, and two were aimed at preventing macroeconomic imbalances. Together the six measures were called the “Sixpack”. The Sixpack applies to all EU countries. The ECOFIN can give specific recommendations when countries do not fulfil the rules but sanctions are only possible for EMU countries (ECo 2011). The following sets out the new conditions of the SGP after the introduction of the Sixpack: • In addition to the 3 per cent rule medium-term budgetary objectives were added. They are defined as structural budget deficits which take into account the specific situation of the country but with a sufficient safety margin not to violate the SGP. • A reduction path was prescribed for countries with debt of more than 60 per cent of GDP. The gap between the current debt level and the 60 per cent level was to be reduced by 1/20 each year.3 The reduction of public debt to 60 per cent of GDP had been included in the Maastricht Treaty but in practice, it was the 3 per cent budget deficit that was the focus. • As part of the so-called preventive arm of the SGP, EMU countries are required to submit annual stability and convergence budgetary plans that fulfil the SGP in the medium-term. As long as budgetary plans do not fulfil the medium-term objectives of the SGP, a new expenditure benchmark is introduced placing a cap on the annual growth of public expenditure in accordance with the medium-term rate of GDP growth of the country. However, public expenditures can increase faster than GDP under the condition that stable financing is guaranteed. The ECo and ECOFIN then examine whether the medium-term budget plans are in accordance with the SGP. If ECOFIN does not agree with a budget

plan, measures to remedy the situation are recommended to the country concerned. The measures are proposed by the ECo but decided by ECOFIN. • The corrective arm of the SGP becomes effective if a member state breaches the 3 per cent deficit limits or insufficiently reduces its debt level of more than 60 per cent. In this case, too, ECOFIN recommends appropriate measures on the basis of the ECo’s advice and sets a deadline for their implementation. If the country does not follow the recommendations sufficiently sanctions can be imposed. • Sanctions to enforce rules of the SGP can be implemented and are recommended by the Commission to ECOFIN. If the latter does not revoke the sanctions by a qualified majority, they will be enforced. Ultimately, despite this complication, compared to the old SGP, the decision to sanction a country that violates the SGP remains a political one. Sanctions could take the form of an interest-bearing deposit, non-interest-bearing deposits or fines. Usually sanctions start with an interest-bearing deposit of 0.2 per cent of GDP and can be step-wise augmented. Let us now turn to the macroeconomic imbalance procedure, which is part of the Sixpack. This procedure implements an early warning system for macroeconomic imbalances in the EU that need to be addressed. By November each year, the ECo produces a report covering all EU countries assessing whether macroeconomic imbalances exist. If they suggest there are, then the country in question is subjected to an in-depth review. This is presented to ECOFIN in February of the following year. On the basis of the in-depth review, ECOFIN decides whether an imbalance exists. If a harmful imbalance is found, ECOFIN makes recommendations to the country, which has to submit a “corrective action plan” featuring a roadmap for all specific policy actions with specific deadlines for implementing adequate measures. The ECOFIN then decides whether the plan is accepted or not. If the country does not follow the recommendations, sanctions up to 0.1 per cent of GDP are possible (i.e., less than in the SGP). The following 14 indicators (ECo 2019) serve as a benchmark for the assessment as to whether an imbalance exists or not. Thresholds indicate what value triggers an imbalance. 1.

Three-year backward moving average of the current account balance as percentage of GDP, with thresholds of +6 per cent and -4 per cent; 2. Net international investment position as percentage of GDP, with a threshold of -35 per cent; 3. Five-year percentage change of export market shares measured in values, with a threshold of -6 per cent; 4. Three-year percentage change in nominal unit labour cost, with thresholds of +9 per cent for euro area countries and +12 per cent for non-euro area countries;

5.

6. 7. 8. 9. 10. 11. 12. 13. 14.

Three-year percentage change of the real effective exchange rate based on consumer price deflators, relative to 41 other industrial countries, with thresholds of -/+5 per cent for euro area countries and -/+11 per cent for non-euro area countries; Private sector debt in percentage of GDP with a threshold of 133 per cent; Private sector credit flow in percentage of GDP with a threshold of 14 per cent; Year-on-year changes in house prices relative to a Eurostat consumption deflator, with a threshold of 6 per cent; General government sector debt in percentage of GDP with a threshold of 60 per cent; Three-year backward moving average of unemployment rate, with a threshold of 10 per cent; Year-on-year changes in total financial sector liabilities, with a threshold of 16.5 per cent; Three-year change in percentage points of the activity rate (percentage of active person in relation to comparable total population), with a threshold of -0.2 per cent; Three-year change in percentage points of the long-term unemployment rate, with a threshold of +0.5 per cent; Three-year change in percentage points of the youth unemployment rate, with a threshold of +2 per cent.

It is not easy to find good indicators for macroeconomic imbalances, and the indicators should not be used in a mechanical way to judge the performance of a country. Overall, it is good practice to have a mechanism to analyse imbalances in a monetary union, but some of the weaknesses of the macroeconomic imbalance procedure are eye-catching. An imbalance is determined when a current account deficit exceeds 4 per cent of GDP and a surplus 6 per cent of GDP. In the case of the international net investment position only a high negative value is considered problematic, whereas positive external asset positions are not considered at all. There is no good economic argument why symmetric definitions of an imbalance in the current account balance and net asset position are not used. A reduction of current account surpluses and thus a smaller build-up of a positive external asset position would not only be easier to manage than to reduce deficits, it also would add to the stability of the monetary union and its social acceptability. The same picture emerges when we look at the development of unit labour costs. If they rise by more than 9 per cent within three years, alarm bells ring. If they stagnate or even fall, it is not considered a cause for concern. Falling unit labour costs are ignored and the associated risks of deflation are extremely destabilizing. Moreover, wage dumping strategies are de facto accepted, even if they run counter to the ECB’s inflation target.

Not all benchmarks for the indicators chosen are convincing. For example, national debt of 60 per cent of GDP as a benchmark is difficult to explain. What is also missing is a judgement of the EMU as a whole. The macroeconomic imbalance procedure has not yet developed any relevant impact. The Country Report Germany (ECo 2017), for example, conducted a comprehensive analysis as to whether there is an imbalance in Germany or not. Among other things, Germany was found to have too high a current account surplus and too little public investment. The review also examined whether Germany had followed the 2016 recommendations. The result was “[o]​verall, Germany has made limited progress in addressing the 2016 country-specific recommendations … The favourable budgetary position indicates available fiscal space, inter alia for providing additional funds – in addition to what has been provided so far – to increase public investment at all levels of government” (ECo 2017: 1f.). In 2019, the country report again attested to a macroeconomic imbalance in Germany. The high current account surpluses and insufficient public investment were again criticized (FN Finanznachrichten 2019). Nothing has happened in response.

Fiscal Compact In 2012, all EU states, except the Czech Republic and the UK, signed the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union, shortened to the “Fiscal Compact” (ECo 2017b). A year later the agreement came into force in 16 of the ratifying states. The status in early 2020 is that the Fiscal Compact applies to all EMU states plus Bulgaria, Denmark and Romania and represents a further tightening of the SGP and the Sixpack. With the Fiscal Compact, binding budgetary rules had to be anchored in the respective national legal systems, preferably at the constitutional level. Member states can go to the European Court of Justice, if they feel that the fiscal rules are not sufficiently implemented in national legislation of a country. The medium-term objective is a government budgetary position close to balance in structural terms and on a sustainable basis. To achieve this, the annual structural deficit must not exceed 0.5 per cent of GDP, unless the debt ratio is well below 60 per cent of GDP. In this case, the structural deficit can be higher, but is not allowed to exceed 1 per cent of GDP. These rules are stricter than in the SGP. If the government debt stock is above 60 per cent, the country must follow a path of debt stock reduction negotiated with the ECo. The 1/20 rule described above also applies here. In the event of extraordinary events and sharp economic downturns, exceptions are possible. However, there has to be a defined adjustment process back to the rules of the pact, which is set by the ECo. In addition, planned public borrowing must be notified in advance to the ECo and ECOFIN.

In the event of rule violations, the ECo proposes economic policy measures which the country must follow. The measures can be modified or cancelled by a qualified majority of ECOFIN. The Fiscal Compact tightened the rules of the SGP further. But this is not the most important point. Sanctions via the SGP have not worked as, so far, there has been no sufficient majority in ECOFIN for this. The hope is that a debt brake in national legislation is more efficient for controlling and sanctioning governments.

Twopack The Twopack from 2013, only valid for the eurozone, was intended to tighten fiscal surveillance further and support coordination of fiscal policy (ECo 2013). According to the Twopack the EMU countries must follow the following procedure: 1.

By 30 April each year, the medium-term fiscal plans together with policy priorities for growth and employment for the forthcoming 12 months have to be published;

2.

By 15 October, the draft public budgets for the following year have to be published;

3.

By 31 December, the public budget has to be adopted for the following year;

4.

The ECo shall examine each draft budget by 30 November. If the ECo detects severe non-compliance with SGP rules it will instruct the government concerned to submit a revised plan. In addition, the ECo’s judgement of the national budget plans will be discussed in the Eurogroup.

During the process budget plans are checked against policy priorities of the EMU. However, the ECo does not have the right to change draft budgets or force governments to follow its recommendations. The Twopack did not tighten sanctions; it only included additional reporting requirements.

European Semester During the European Semester compliance with the many regulations in the field of fiscal policy are checked and, if necessary, recommendations are given and sanctions implemented. In this process the ECo and ECOFIN are interlinked. But ultimately ECOFIN decides, for example, whether sanctions are imposed. In the European Semester attempts were made to implement the “Europe 2020 Strategy” together with fiscal rules. The focus of the Strategy is to increase the EU’s competitiveness. Essentially based on neoliberal ideas, it is purely supply-oriented. The overarching objectives are the implementation of a knowledge-based

and innovative economic growth strategy, which includes the protection of natural resources and the limitation of climate change. In addition, a high level of employment should be achieved and poverty tackled. The responsibility to implement the strategy lies with the respective countries.

Summary The broad and differentiated range of new rules has the primary objective of guaranteeing fiscal discipline. The macroeconomic imbalance procedure is a positive step but has not yet had much practical effect. Many criteria in the field of fiscal rules and recommendations are arbitrary. A long-term maximum structural budget deficit of 0.5 per cent of GDP, as in the Fiscal Compact, limits fiscal policy and most likely reduces public credit-financed investment without the need to do so. Added to this are “technical” problems in the implementation of the programmes. For example, the distinction between structural and cyclical budget balances is by no means convincing. It is most likely that the rules will lead to insufficient countercyclical fiscal policy or might even have a pro-cyclical effect. Although higher budget deficits are permitted in the event of deep recessions, there are no rules on how to react jointly in the EMU or the EU to them. Joint activities in the fiscal field are in fact not planned. None of the new regulations has advanced political integration or the strengthening of the fiscal centre in the EU or EMU. For example, no supranational institution has been created that can levy taxes, is allowed to realize budget deficits and take credit. There is simply no centre in the EMU that could pursue a discretionary fiscal policy. No institutions for implementing major joint public investment programmes – such as a Europe-wide network of fast trains to peripheral countries or a joint ecological energy turnaround – have been established so far. Social dimensions of integration in the EMU, let alone the EU, are missing. Instead of further integration in the EMU that is worthy of the name and is accompanied by macroeconomic coordination, a hodgepodge of rules, controls, assessments and sanctions have been implemented. In the next severe crisis, it is likely that no adequate fiscal action will be taken. It is also conceivable, of course, that the regulations will be simply ignored, so that countries can react more appropriately. After all, ECOFIN has established itself as the centre of power, which ultimately decides on sanctions in the event of rule violations, and has a great deal of leeway in this respect. Overall, the judgement is that the ECB still has no supranational partner, which could make macroeconomic management of the EMU more efficient and easier.

12 FINANCIAL MARKET SUPERVISION, BANKING UNION AND FINANCIAL MARKET REGULATION

During the financial market crisis of 2007/08, it became abundantly clear that the regulation of the financial system was in need of fundamental reform. Basel II, which formed the basis of financial market regulation before the subprime crisis, was at least partly to blame for the financial meltdown (Goodhart 2008). In the EMU there was the additional problem of the lack of common financial market supervision – an absurdity for a monetary union. The EMU thus faced a double task: to adopt better regulations for the financial system and at the same time to develop a new architecture for European financial market supervision. In the following, the new institutional structure of financial market regulation will be discussed first, and then the creation of the Banking Union in the EMU and finally the reform of the financial market regulations will be presented. We refrain from making comparisons with the United States, as this would go beyond the scope of this chapter.

The new structure of financial market supervision in EMU In 2011 and 2012, after lengthy consultations, the European System of Financial Supervision (ESFS) was created, which applies to all EU member states (see also Herr et al. 2019). The subprime crisis had revealed that the pre-crisis philosophy of financial market supervision under Basel II was inadequate. Basel II was developed in the 1990s following the triumph of neoclassical models. It is theoretically based on the ideas of efficient financial markets and of the rational behaviour of economic entities (i.e. that microeconomically derived rational behaviour always leads to macroeconomically desirable results). This approach ignores numerous theoretical objections as well as the recurring crises in financial markets. Individually rational behaviour can lead to irrational results for the whole economy (Herr 2011). For example, at a concert, it can be quite rational for an individual to stand up to have a better view. But if all visitors of the concert follow this individual rational behaviour, the irrational result is that all people are standing and none can see well. If in a financial market panic, all wealth owners want to sell their securities in order to obtain liquidity, there are no buyers and prices crash through the floor and liquidity vanishes. Basel II had succumbed to the illusion that microeconomic-based financial market supervision reliant on the soundness

of individual financial units would be sufficient to maintain financial market stability. How could the expertise of legions of economists and bankers have come up with such an idea? One reason was certainly the successful lobbying of financial market agents, who argued that their sophisticated risk models were the ideal and sufficient instrument for financial market supervision. As a result, Basel II was pushed through politically and implemented in almost all Western countries. Martin Hellwig (2008: 55), a well-known financial market expert, explained: “I think of this process as regulatory capture by sophistication”. In order to eliminate the weaknesses of Basel II, in European financial market supervision, a second pillar was established alongside the reform of the microeconomic supervision of financial institutions. The aim of the new pillar was explicit macro-prudential supervision. Figure 12.1 shows the structure of the ESFS.

Figure 12.1

European system of financial supervision

We begin our elaborations with the structure of micro-prudential institutions for supervising the financial system. All of them were created or reformed after the 2008 financial market crisis and the Great Recession. At the European level, the European Supervisory Authorities (ESAs) were founded, which consist of three institutions.1 The first of the three institutions is the European Banking Authority (EBA) based in

London (EBA 2020). Its most important decision-making body is the Board of Supervisors. All important decisions are taken here. The Board of Supervisors elects the members of the Management Board, including the Chair. Voting members of the Board of Supervisors are the EBA’s Chairperson and national representatives of the banking supervisory authorities of all EU countries. Representatives of the ECo, the ECB, the two other supervisory authorities of the ESAs and the European Systemic Risk Board (ESRB), the key institution for macroprudential supervision, participate in meetings without voting rights. The main function of the EBA is to develop and continuously adapt a single European rulebook for financial sector supervision in the EU. This set of rules is designed to provide uniform and harmonized supervisory rules and supervisory practices for financial institutions in the EU, thereby helping to create a level playing field for all financial institutions. It also aims to ensure the protection of depositors, investors and consumers. Where national authorities have different views on regulation and/or are in breach of European law, the EBA can take action. It also has a mandate to identify risks and vulnerabilities in the EU banking sector, in particular through regular risk assessment reports. To this end, the instrument of EU-wide stress tests has been introduced and is carried out by the EBA. However, the EBA does not directly supervise financial institutions. The second supervisory authority is the European Securities and Market Authority (ESMA) with headquarters in Paris (ESMA 2020). The function of ESMA is to identify risks in securities markets, to supplement the Single Rulebook and to promote compliance to regulations and the same monitoring standards in the EU. In member countries, ESMA directly supervises credit rating agencies and trade repositories.2 All other areas remain under the supervision of national authorities. The Board of Supervisors and Board of Management function similarly to the EBA. Voting rights in the Board of Supervisors are also held by the Chair of ESMA and representatives of the national supervisory authorities for securities markets. Representatives of a number of other organizations such as the ECB, the two other institutions of the ESAs and the EU Commission participate in the meetings of the Board of Supervisors in an advisory capacity. Finally, the third authority is the European Insurance and Occupational Pensions Authority (EIOPA) based in Frankfurt (EIOPA 2020). Its function is particularly to increase the transparency of financial products and to identify risks. This institution has no competences at national level. EIOPA initiates and coordinates stress tests in the EU in the insurance and occupational pension sector. Voting members of the Board of Supervisors are also the Chair of the Board of Management and representatives of the national supervisory authorities in the EU in the insurance and occupational pensions sector. There are also a number of non-voting members on the Board of Supervisors, such as representatives of the EU Commission, EBA and ESMA. The three institutions of the ESAs have a Joint Committee. Top representatives of the

three organizations meet at least once every two months. Apart from in small areas, all three authorities seek to harmonize their activities and do not displace national authorities. A transfer of national supervisory competences to a supranational institution occurs to a very limited extent in these institutions. The second pillar of the newly created European financial supervision system created the European Systemic Risk Board (ESRB) at European level in 2010 (ESRB 2020). The establishment of an EU institution to monitor and, if necessary, combat macroeconomic and systemic risks goes back to the De Larosière Report of 2009 (De Larosière et al. 2009), which stressed the need for such institutions in the wake of the financial market crisis. All important decisions in the ESRB take place in the General Board. There are three other committees in the ESRB: the Advisory Scientific Committee, the Technical Committee3 and a Steering Committee, which supports the work of the General Board. The General Board is chaired by the president of the ECB. In addition, the General Board includes the vice-president of the ECB, the governors of all national central banks, one member of the ECo, the Chair of all three ESAs, the Chair and the two vice-Chairs of the Advisory Scientific Committee and the Chair of the Advisory Technical Committee. It is a very large body, but it brings together all the major European institutions in the field of financial market supervision. The ESRB has the task of identifying systemic risks in the EU financial system on the basis of comprehensive macroprudential analyses. The monitoring, assessment, warnings and recommendations cover not only the banking system but also the whole area of the shadow banking system, such as investment banks, hedge funds, derivatives trading, etc. To take on this task, the ESRB regularly writes reports and examines the financial system by means of a dashboard containing around 70 quantitative and qualitative indicators, which provide a comprehensive picture of the situation of the financial system in the EU. For example, in the last annual report of the ESRB (2019) the risk in global financial markets and particularly loans to emerging market economies was considered very high. According to the report, shocks to risk premiums in this field cannot be excluded. In addition, in the financial system in general the mispricing of risks and excessive risk-taking, as a result of the search for yields, were cited as creating high risks. Some banks, insurance companies and pension funds in the EU were considered to be at high risk due to their low profitability. The risk was also estimated to be high for private and public households in the EU, which could run into problems in the event of economic shocks due to their high levels of debt. The ESRB can make recommendations for concrete policies for the EU as a whole, but also to individual member states. It can contact central European institutions like the ECo and national institutions for financial market supervision. However, it has no right to intervene in the policies of countries and cannot force the implementation of its recommendations.

In addition, at the national level macroprudential institutions have been established in all member states to identify and, if necessary, combat financial market risks in their own countries. It was left to the individual countries to decide where to locate these institutions, for example at the central bank or as a separate institution. In Germany, for example, the Financial Stability Committee was established in 2013 and is based at the Federal Ministry of Finance (Buch et al. 2016). This committee consists of three members from the Deutsche Bundesbank, the Federal Financial Supervisory Authority (BaFin) and the Federal Ministry of Finance plus, without voting power, the chief executive director of BaFin’s Resolution Directorate. The committee writes an annual report for the Deutsche Bundesbank. Decisions are made with a simple majority. However, the issuance and publication of warnings and recommendations and the annual report should be based on the broadest possible consent. The committee itself has no power to impose policies deemed relevant to financial stability. These decisions are made by BaFin. However, it can issue warnings and recommendations which are available for the general public. If recommendations are not followed reasons must be provided by BaFin. It is worth noting that the Deutsche Bundesbank has a veto right on committee decisions and publications. Overall, the power relationship within the German Financial Stability Committee is complex. The Deutsche Bundesbank has a veto but decisions are made by the BaFin and in the end the Federal Ministry of Finance. In the framework of Basel III for macroprudential policies a number of new instruments were created, especially different buffers. Before we analyse these instruments, we turn to the issue of the European Banking Union.

The European Banking Union In the ESFS supervision of banks lies exclusively with national authorities. The member states of the eurozone have decided to create a more far-reaching integration of financial market supervision. EU countries outside the EMU can voluntarily join the European Banking Union (BU), which consists of three pillars: the single supervisory mechanism; the single resolution mechanism; and the European deposit insurance scheme (ECo 2020a). Under the single supervisory mechanism banking supervision of large banks in the EMU was transferred to the ECB in 2014. Banks are defined as significant if they meet one of the following three criteria: (1) they have a balance sheet total of more than €30 billion; (2) they have a balance sheet total of more than 20 per cent of the country’s GDP; or (3) they are among the three largest banks in the country. Using these criteria, in the EMU about 120 banks out of 6,000 are directly supervised by the ECB. Together they account for around 85 per cent of the balance sheet total of all financial institutions. Smaller banks continue to be monitored by national authorities. However, the ECB also has the power to intervene in the

supervision of small banks in EMU countries. The single resolution mechanism came into force in 2015. Its aim is to ensure the orderly, uniform restructuring or winding-up of financial institutions with problems. Before the financial market crisis, there was no EMU-wide mechanism and these procedures were regulated differently in the various EMU countries. Especially for financial institutions operating across borders, a supranational restructuring or winding-up became necessary. Another aim of the single resolution mechanism is to save taxpayers’ money in financial crises as much as possible. Shareholders of banks and big creditors, who are not covered by deposit insurance schemes, should shoulder some of the financial losses. In the subprime crisis it was primarily the taxpayer who had to step in when financial institutions had problems. To implement the single resolution mechanism in the EMU, a Single Resolution Board was founded in 2015 as a central, independent organization. Its task is to develop or implement rescue plans in case they are needed for one of the large banks supervised by the ECB. If the ECB identifies serious problems at a bank, the Single Resolution Board meets and within a short period initiates a rescue plan or a plan to wind-up the financial institution. The plan is submitted to the ECo and ECOFIN is also notified. The ECo can reject the proposal of the Single Resolution Board as well as governments of member states. It is possible to rescue a bank despite insolvency and recommendations by the Single Resolution Board to wind it up, for example, a government can stress the special role of the bank for the country or its systemic importance to prevent its closure. In 2016, the Single Resolution Fund was established to deal with cases where private sources are not sufficient to rescue or wind-up a bank. Before the fund can be used, private loss participation of at least 8 per cent of the bank’s balance sheet total is required. The fund is financed by a bank levy, which depends on the size of the institution and the extent of the risks taken. The fund will gradually increase to €55 billion in 2023, which corresponds to approximately 1 per cent of the deposits in the euro area covered by deposit insurance. The single resolution mechanism does not have the same quality as the single supervisory mechanism. In the latter, the ECB has control over the large banks and a right of intervention over national supervisors. In the single resolution mechanism, there are a number of regulations that allow the countries in the EMU to rescue national banks even against the will of the Single Resolution Board. In 2016, for example, the major Italian bank Banca Monte dei Paschi di Siena was rescued by the Italian state with €5.4 billion on the basis of an exception, although this was more than questionable under the single resolution mechanism (ECo 2017a). Moreover, although a fund equal to 1 per cent of deposits in the EMU covered by deposit insurance may be sufficient to rescue and/or wind-up a single bank without taxpayers’ money, the fund is underfunded in the event of a systemic financial market crisis. This was

shown by an IMF study, which concluded that the net cost of bailing out banks during the subprime crisis in Germany amounted to around 10.7 per cent of German GDP by 2011 (IMF 2011: 8). This means that the costs for taxpayers in Germany amounted to around 16 per cent of bank deposits.4 The single resolution mechanism, including the Single Resolution Fund, does not lead to a joint EMU-solution about how to handle the concentration of non-performing loans in single member countries. The ECB (2020f: 68) shows that in December 2019 non-performing loans in Greece were still around 35 per cent of banks’ credit volume and 6.7 per cent in Italy. National solutions to solve the non-performing loan problem are problematic as countries with high non-performing loans usually also have high public debt quotas. Thus, the banking union has until now not offered a solution to old or newly created high stocks of nonperforming loans in single member countries and high stocks of government debt. The European deposit insurance scheme is intended to establish a joint deposit insurance scheme in the EMU. It is necessary to reduce capital flight within the EMU, which occurs when deposits in one country are not considered safe, and massive amounts of monetary wealth shift to stable countries. This was the case in the EMU after 2010 and led, among other things, to the explosion of Target2 balances and the ECB balance sheet. A second problem is that there is a link between confidence in banks and the fiscal situation of the country in question. This is because when banks get into trouble in a systemic crisis and the country’s government wants to help the banks, it drives up the budget deficits and the state’s debt. If banks in a crisis country hold government bonds from their own government and public debt explodes, the risk of these bonds increases if there is no lender of last resort for public households. An extreme case is Ireland. In 2007 Ireland had a public debt to GDP of 27.5 per cent. Debt exploded to 131.9 per cent of GDP in 2013 mainly because financial institutions were bailed out (OECD 2020). A joint deposit insurance scheme would therefore significantly stabilize the EMU. The original 1994 regulation provided for only minimal harmonization of domestic deposit guarantee schemes in the EU. An amending directive in 2009 required EU countries to increase their protection of deposits to a uniform level of €100,000 by the end of 2010. But the deposits that are protected are defined differently in different countries and the insurance schemes are organized differently. Furthermore, there are doubts whether the national deposit guarantee is sufficient to protect deposits in a deep financial market crisis. In a monetary union, a common deposit guarantee for all banks would be necessary to stabilize the financial system. Until today EMU-wide deposit insurance could not be established. It is anathema to Germany and some smaller countries, which are afraid of having to pay for financial problems in banks, for example, in the southern countries of the EMU. Joint deposit insurance would stabilize capital flight within the EMU in a financial crisis but it would not stop it. As soon as banks in one country of the EMU come into crisis wealth

owners, who hold liquidity in banks not protected by deposit insurance, will immediately shift their monetary wealth to stable banks in other parts of the EMU. In a confidence crisis, holders of bank bonds try to sell them, and prices of bank bonds and bank shares massively lose value. Such processes take place in all countries of the world but the specific problem in the EMU is that the banking system is still largely regionally based and big banks that are important in all countries of the monetary union do not exist. Thus, in the EMU regional banking crises with capital flight are much more likely and much more severe than in normal nation states. It also should be mentioned that in the EMU no joint capital market exists. Rules at the different stock exchanges in the EMU are different, as is taxation. Benjamin Cohen (1998: 157) predicted that a single currency “will increase the homogeneity and liquidity of European markets … it could be a very long time before all traces of segmentation disappear”. But this is not the only problem to developing an EMU capital market. As there are no euro bonds issued by a central fiscal institution, the EMU lacks an EMU-wide safe asset comparable to US government bonds.

New rules in the regulation of the financial markets The financial market crisis and the Great Recession led not only to new institutions in the EU, but also to numerous new financial market regulations. The new regulations are broadly in line with the Basel III rules, which were officially adopted in 2010. Basel III, like Basel I and Basel II before it, was developed by the Basel Committee on Banking Supervision (BCBS) at the Bank of International Settlement in Switzerland. The BCBS is composed of central bank governors and presidents of banking supervisory authorities of all industrialized countries and a large number of other countries (Herr 2016; Detzer & Herr 2015). As mentioned, the regulation of financial markets in recent decades has been largely shaped by the BCBS established in 1974 following turbulences in financial markets after the breakdown of the Bretton Woods system. Basel I was then adopted in 1988 as a set of rules and regulations and served as a guideline for financial market regulation worldwide. Central to Basel I was that banks should hold a capital equivalent to 8 per cent of the risk-weighted total amount of credits issued. Under the standard method four types of credits were distinguished. In the case of loans to public-sector entities in Organisation for Economic Cooperation and Development (OECD) countries and deposits with central banks the risk weight was zero per cent, so that no capital had to be held on them. Loans to banks in the OECD and public-sector institutions like public utilities were weighted at 20 per cent, meaning that 8 per cent capital had to be held of 20 per cent of the loan. For mortgagebacked securities the risk weight was 50 per cent and for all other exposures to households and corporates 100 per cent.5

This principle of risk-weighted capital holding was decisively modified in Basel II, which was adopted in 2004 but had already been introduced in part before then. In order to calculate the legally required capital holding, banks could now choose between the standard approach and their own internal risk assessment. In the latter case, banks were allowed to use individual risk models.6 The risk weights were thus no longer prescribed in general terms, but were determined by the bank’s individual risk model. Unsurprisingly, this change in the calculation method enabled banks to significantly reduce their capital holdings in relation to credits given (Hellwig 2008). Another problem is that these models contained strong pro-cyclical elements. They are based on statistical data from the past. Whether the past is a reliable guide for the future of financial systems, which are not ruled by physical laws but by historical developments, is highly questionable. In any case, driving a car, while looking in the rear-view mirror, is not a sensible idea. Let us take an expansionary phase with a combination of relaxed-loans origination standards and easy credit. In such a phase even marginal borrowers are able to refinance their investment and are able to fulfill their obligations. The impression is that default risk is low: “Because of the procyclical bias of capital measurement techniques, this low level of ‘observed’ default risk is fed into bank risk models, which results in an underestimation of required capital for both regulatory requirements and the bank’s own internal benchmarks” (Zamil 2010: 46). Independent of this many arbitrary elements were built into risk models. For example, it remains arbitrary how many years one goes back in the calculations of risks, how great is the weight of the different periods of the past, and to what extent one eliminates past financial market crises as “disruptive factors” which disturb the model. For example, in phases of the build-up of a real estate bubble the calculated default risks of credits in risk-models are low, in spite of the fact that the fragility of the financial system is increasing and the danger of future non-performing loans is high. These models are therefore extremely unsuitable for forecasting major financial market crises in particular. Financial market regulations based on Basel II were thus partly responsible for the subprime crisis (Herr 2011). Even for the most radical supporters of unregulated financial markets it became clear that reforms to Basel II were needed. The G20 meeting in London in 2009 laid the foundations for the reform of financial market regulation in the wake of the subprime crisis. In 2009 the Financial Stability Forum, which was founded in 1999 to promote international financial stability and to coordinate cooperation in financial market supervision, was transformed into the Financial Stability Board (FSB). The Financial Stability Forum was located at the Bank of International Settlement and had finance ministers and central bankers of the important Western industrial countries as well as significant international institutions as members. The FSB remained in Switzerland and now includes all G20-countries. It was given the task to coordinate and supervise the implementation of G20-decisions, which were seen as necessary

to make the financial system more resilient. The philosophy behind this reform was that, first, the unregulated shadow financial system is central to efficiency and growth in capitalist economies and that this sector should not be much affected by the reforms. Secondly, the global financial markets, as the backbone of the way globalization has been conducted since the 1970s, should not be restricted. At the G20 meeting in Washington in 2008 it had been stated: “We will make regulatory regimes more effective over the economic cycle, while ensuring that regulation is efficient, does not stifle innovation, and encourages expanding trade in financial products and services” (G20 2008: 3). The meeting a year later confirmed the strategy: “Financial markets will remain global and interconnected, while financial innovation will continue to play an important role to foster economic efficiency” (G20 2009: V). To have stricter regulations of the banking system was considered to be sufficient in establishing a stable financial system, the non-bank financial and the international financial system should not be fundamentally changed. This argument is a surprise as the non-bank and international financial system was at the core of the 2007 financial market meltdown starting in the US. In the following, we shall outline the most important banking regulations in the EMU based on Basel III. With regard to the banks, in particular capital requirements were increased and various capital buffers were introduced (BaFin 2020). The new regulations are shown in Table 12.1. Table 12.1 Capital requirements for banks in the EU (% of risk-weighted assets) For all banks (a) Basic capital holding 8.0% (b) Capital conservation buffer 2.5% (c) Minimum capital holding for all banks (a) + (b) 10.5% Additional capital holding Countercyclical capital buffer 0–2.5% Capital buffer for global systemically important banks (G-SIBs) 1–3.5% Capital buffer for other systemically important institutions (O-SIIs) 0–2% Systemic risk buffer 1%+ Source: European Council (2020).

The first requirement, based on risk models, was that all banks must hold at least 8 per cent of their risk-weighted assets in capital. Of the 8 per cent, at least 4.5 per cent (2 per cent under Basel II) must now be held in common capital. Common capital consists basically of own shares, open reserves and retained earnings. It is immediately available to cover losses. The remaining portion to cover the 8 per cent can be held in other forms of capital not immediately available to cover losses.7 Secondly, in addition to the 8 per cent banks must hold a capital conservation buffer in

common capital amounting to 2.5 per cent of banks’ risk-weighted assets. This buffer had to be established by 2019. It can be temporarily reduced in a crisis situation, but must be rebuilt afterwards. If a bank falls below the required value of the capital conservation buffer, it is limited in its dividend payment, among other things. This means in normal times all banks have to keep 10.5 per cent capital in relation to their risk-weighted assets whereas 7 per cent must be in common capital. Additional buffers were introduced that do not apply to all banks and at any time and have different purposes. The countercyclical capital buffer reduces the pro-cyclical dynamic of asset markets and remedies parts of the shortcomings of risk-models that intensify pro-cyclicality. It has to be kept in common capital and can be up to 2.5 per cent of banks’ risk-weighted assets. The application of this buffer is decided at national level by the respective member state and applies to all banks active in the country in question. In Germany, for example, the BaFin decides on the application of the buffer. When making its decision, BaFin takes into account recommendations of the ESRB and the national Financial Stability Committee. In early 2020 in the EMU, France had a countercyclical capital buffer of 0.25 per cent, Slovakia of 1.5 per cent; Germany introduced one with 0.25 per cent in July 2020 (ESRB 2020). Furthermore, three types of buffers were created to make systemically important institutions more stable. The first buffer applies to global systemically important institutions (G-SIBs) and was fully introduced in 2019. This buffer has to be held in common capital and has a value between 1 per cent and 3.5 per cent of risk-weighted assets. The buffer can be set individually for each globally active bank. FSB and BCBS determine which banks are globally systemically important. The criteria are size, interconnectedness, substitutability, complexity and cross-jurisdictional activity. In early 2020 around 30 global banks were forced to fulfil this buffer, in the EMU it applied to 8 banks (see European Parliament 2017).8 The second capital buffer was created for other systemically important institutions (OSIIs). These institutions are identified at the national level based on size, economic importance for the host country and other European countries, cross-border activity and interconnectedness with the financial system, following EBA guidelines. This buffer, also held in common capital, can have values between 0 per cent and 2 per cent. For example, in early 2020 in Germany 13 institutions were forced to keep this buffer, Deutsche Bank with the highest percentage of 2 per cent, followed by Commerzbank with 1.5 per cent, UniCredit Bank with 1 per cent, etc. (BaFin 2020). The third and final capital buffer – the systemic risk buffer – is also kept in common capital and decided at the national level. This buffer can be introduced for all institutions or certain groups of institutions in a country, but not for single institutions. It should have a value of at least 1 per cent and has no upper limit. Should this buffer exceeds 3 per cent, the ECo, the EBA and the ESRB must be notified; should it exceed 5 per cent, the ECo’s

permission is required. Early 2020 systemic risk buffers are for example used in the Netherlands (3 per cent) and in Finland (1–3 per cent), but not in Germany to date (ESRB 2020). Generally, credit institutions must only comply with the highest of the three buffers aimed at combating systemic risks. The current rather complicated rules for capital holding of banks do not entirely rest on banks’ risk models with all their weaknesses. A leverage ratio independent of risk models was also introduced. Banks must hold at least 3 per cent common capital in relation to their total exposure. Exposure comprises both on-balance sheet and off-balance sheet items. Offbalance sheet items are, for example, guarantees given by banks. Another weakness of the financial system before the subprime crisis was that financial institutions held large amounts of securitized loans as liquidity. It was assumed that securities could be sold any time on liquid secondary markets. However, securitized loans can quickly lose their character as liquidity. This was impressively demonstrated during the panic in the financial market crisis of 2008 when securities quickly lost their liquidity because nobody wanted to buy these securities anymore. For this reason, under Basel III two liquidity ratios were introduced which had to be met. First, banks must maintain a liquidity coverage ratio which covers expected outflows during the next 30 calendar days with short-term liquidity. Second, according to the net stable funding ratio long-term assets with a residual maturity of more than one year must be matched fully by long-term funding.

Assessment of the financial market reforms After the subprime crisis, the financial system was reformed in the EU and more so in the EMU by a great number of new institutions and regulations. All these reforms without doubt made the financial system more resilient. The question is whether the reforms are sufficient to prevent a new systemic financial crisis with high social and economic costs. With regard to financial market supervision, the EMU has taken a major step forward in terms of integration. In the BU banking supervision of major banks in the EMU is now directly conducted by the ECB and the latter can directly intervene in banking supervision of smaller institutions in member states of the EMU. Supervisory rules and their adjustment are decided at EU level. In contrast, supervision of non-bank financial institutions, insurance companies and pension funds, in short the shadow-financial system, is not supervised by a supranational institution and there is significant national leeway. In the BU progress has also been made in restructuring and winding-up banks with problems, but there are still many loopholes in the regulation that allow national strategies, for example, to prevent the resolution of banks. A common insurance for bank deposits has not been created in the EMU. This remains a source of instability in coming crises, as high capital flows from crisis

countries to more stable countries within the EMU must be expected. Macroprudential supervision in the EMU is now well developed. A major build-up of systemic instability should therefore be detected at an early stage. It remains open, however, whether the instruments that can be used to prevent financial crises are strong enough. It should also be borne in mind that, despite all the symptoms of the crisis, the experts at the IMF, the ECB, the Fed and many other central banks did not see the financial crises of 2007/08 coming or at least did not sufficiently warn of it. So it remains open whether the macroprudential institutions in future show more courage to clearly identify undesirable developments, even against the interests of financial market players.9 The regulation of the financial system in the EMU based on Basel III remains problematic. Firstly, the regulatory framework remains inconsistent. On the one hand risk models with their pro-cyclical effects and blindness to the accumulation of particularly systemic financial instabilities still play a major role for capital holdings of banks. On the other hand the role of the risk model is constrained by the leverage ratio. Individual risk models of banks should have been abandoned altogether. To go back to the standard approach in Basel I would have been an alternative. Or, it could be improved and differentiated further. Different risks of credits given by banks can be sufficiently reflected in the different interest rates charged. Secondly, the capital adequacy of banks could also have been increased more significantly. Due to the use of risk models, capital holding of banks also in the future will be minimized. Related to this question is whether a countercyclical capital buffer of 2.5 per cent stops the financial system in a boom giving more risky credits or whether a capital buffer for global systemically important banks of 3.5 per cent makes the global financial system safer. In response to the question of how high should the banks’ equity be, Martin Hellwig replied: “In the order of 20 to 30 percent of the balance sheet total. The banks say they could not do this, but that is wrong. They don’t want that because issuing new shares would harm the existing shareholders – a pure lobbying argument” (Hellwig 2017). Capital holding of 30 per cent of banks’ assets would substantially increase the loss absorption capacity of banks and would make the system more stable.10 This brings us to more fundamental problems. The banking supervision rules control capital holding, which is on the liability side of the balance sheet of banks. But risks are taken on the asset side of banks. Even high capital holding cannot prevent highly risky activities of banks. If a bank acts in a very risky manner, the existing capital holding rules will not help much. Capital holding according to existing rules will never be high enough to cover major losses of a bank: “Because banks are highly leveraged, a small miscalculation in asset valuations can lead to a large impact in reported capital ratios. For example, a 4 percent decline in asset values equates to a 50 percent drop in the minimum 8 percent capital ratio, using a simple capital to assets measurement methodology” (Zamil 2010: 46). And the

valuation of capital is difficult. For most loans and especially problem loans there are no observable market prices and valuation depends on many arbitrary assumptions. In this context, it is understandable that Hellwig recommends capital holdings of banks up to 30 per cent of assets. What would be needed is strict supervision of the asset side of banks. Rules should clearly fix which types of banking activities are allowed and which not. And supervisors should very closely analyse the business models and investment activities of banks and restrict activities if needed (Zamil 2010). Another major problem of the existing financial market supervision is that the shadow financial system has not been more heavily regulated. The links between banks and non-bank financial institutions in the form of ownership and credit relationships have not been cut, which is the least that should have been done in a situation of only light regulation of the shadow financial system. Post-crisis the financial system in the EMU could have been reformed along the lines of the Glass–Steagall Act of 1933 which separated commercial and investment banking in the United States. After the subprime crisis similar ideas were enshrined in the Volcker Rule, which, under a strict separation of banks and non-bank financial institutions, regulated that the more risk-loving units in the financial system would have to manage without large credit leverage and would have to finance themselves via the non-bank sector. A collapse of the shadow banking system would then not have the same consequences as in the subprime crisis. But even under such a regulation more rules and transparency in the shadow financial system would be desirable, for example by allowing financial innovation only after a check by supervisors. Almost completely excluded from the regulation of financial markets is the international monetary system, which from the 1970s onwards became a source of instability, not only between industrialized countries but also between industrialized and developing countries. In this context, unstable international capital flows and high levels of debt in foreign currencies are a dangerous blind spot of financial market regulation. Many of the short-term international capital flows in particular do not bring any economic benefit and are of a purely speculative nature. This applies from exchange rate speculation to international speculation in real estate or commodities markets. Not even the drying-up of offshore centres has been substantially addressed, not even within Europe. Regulations in property markets have been reduced in recent decades. The US subprime crisis and developments in Europe and many parts of the world have shown that property markets can become a major source of instability and social inequality if they are not regulated. So far, no serious steps have been taken to regulate real estate markets in such a way that they are stable and contribute to social equity in society. The past has shown that well-regulated and comparatively simple financial systems, which restrict destabilizing and risky activities of financial institutions on the asset side of the balance sheet, are less crisis-prone and can create economic prosperity. It would be highly

desirable that the EMU completes the BU and implement regulations that make financial markets in the EMU and worldwide more stable.

13 THE COVID-19 CRISIS AND ITS EFFECTS ON THE EMU

Following the 2009 Great Recession, the EMU has experienced modest growth overall. The annual growth rate of GDP from 2010 – the first year of the recovery – to 2019 averaged 1.36 per cent. In 2012 and 2013 growth was negative and in 2019, before the outbreak of the Covid-19 crisis, it was only 1.2 per cent (Eurostat 2020). Figure 7.1 shows that the EMU countries performed differently. Italy’s economy, for example, remained in stagnation and Greece has far from overcome the effects of the sovereign debt crisis of 2010. In 2019, ECB refinancing rates were still at zero and it had restarted its monthly net interventions to buy public and private bonds. There were already clear signs of an economic downturn in the second half of 2019, although the extent of this was not yet clear. The Covid-19 crisis, which came to a head in early 2020, was consequently untimely for Europe. Despite all the uncertainty of forecasts, it is clear that the Covid-19 recession will be profound. The ECo (2020b) expects EMU GDP to shrink by 7.7 per cent in 2020: 6.5 per cent in Germany, 8.2 per cent in France, 9.4 per cent in Spain, 9.5 per cent in Italy and 9.7 per cent in Greece. This economic slump will be the most severe Europe has experienced since the Second World War. As in the Great Depression of the early 1930s, fundamental economic and political changes cannot be ruled out. In early summer 2020, as we write this chapter, economic development in the immediate future remains extremely uncertain. The immediate reaction of EMU member states to the Covid-19 crisis demonstrated yet again how uncoordinated the EU still is in the face of threat. At the outbreak of the pandemic, each country tried to navigate the emerging problems alone. Some countries, such as Austria, initially ignored the health hazards, only then to close its borders to neighbouring countries without consultation. Other countries quickly followed suit. In addition, each country adopted its own health protective measures, such as differently targeted travel bans, specific shutdowns for schools and restaurants or curfews or social distancing rules. The ECo was demonstrably too weak to play a coordinating role. But the European Council was also unable to find a common European response to the crisis. The same was true of the Eurogroup, which was also unable to agree a common line for the eurozone. Instead, fierce conflicts developed between the individual EMU member states. As in the past, the southern and northern European countries were virtually irreconcilable, with France this time occupying the middle ground. However, the extent of the economic crisis has also increased the pressure in the EMU to pursue common policies.

Monetary policy measures in the Covid-19 crisis The ECB’s monetary policy measures in the Covid-19 crisis must be seen in the context of a monetary policy that had not yet returned to normal after the Great Recession. The ECB’s refinancing rate was lowered to 0.05 per cent in September 2014 and has remained at zero since March 2016. At this interest rate, banks can be refinanced by the ECB without limit, provided they possess acceptable collateral. The ECB has continuously reduced the claims on collateral so that the refinancing of banks does not fail due to their lack of collateral. The interest rate for bank deposits at the ECB – the deposit facility – was negative from June 2014 and reached its lowest level of -0.5 per cent in September 2019. This means that banks will lose 0.5 per cent interest when they hold deposits with the ECB. Also in September 2019, the ECB Governing Council decided – after a short cessation from December 2018 – to restart the asset purchase programme from November 2019 onwards, this time with monthly net purchases of €20 billion. This had all happened before the outbreak of the Covid-19 crisis in anticipation of a looming economic crisis. When the extent of the Covid-19 crisis became clear, the ECB decided to intervene with an additional €120 billion on 12 March 2020. Moreover, in March, the targeted longer-term refinancing operations (TLTROs), which had already been underway since 2014, were further relaxed, making refinancing even more attractive for banks when lending to the private sector (see Chapter 10). The interest rate for TLTRO-financing fell to 0.25 per cent below the interest rate of the deposit facility, which means the interest rate was -0.75 per cent. In April, the interest rate on these transactions was lowered further to -1 per cent: banks received 1 per cent interest when they borrowed from the ECB to lend to the private sector. In order to secure liquidity, particularly in the corporate sector, the pandemic emergency longer-term refinancing operations (PELTROs) to the tune of over €850 million were also agreed at the end of April 2020. Banks taking advantage of this programme benefitted from collateral easing measures and an interest rate of 0.25 per cent below the interest rate for main refinancing operations. Under this programme banks can refinance loans to companies at an interest rate of -0.25 per cent (ECB 2020). It has been reported that the PELTRO garnered little response, which is not surprising as the more attractive TLTRO provided sufficient refinancing for banks (4investors 2020). In terms of volume, the largest programme to stabilize the financial system and public budgets was the pandemic emergency purchase programme (PEPP) adopted in March 2020, which provided for interventions by the ECB to the amount of €750 billion over the course of 2020. The PEPP plus the €120 billion from early March amounts to 7.3 per cent of euro-area GDP of 2019. Overall, the ECB’s pledged interventions are huge. Between the end of 2007 and the end of 2019, the ECB’s balance sheet total has more than tripled and already amounted to 26.6 per cent of eurozone GDP at the end of 2019. This figure is likely to rise to

well over 35 per cent in 2020 (see ECB 2020a). The previous asset purchase programmes (APPs) of the ECB followed the logic that the ECB could buy securities according to the ECB’s capital key. The PEPP deviated from this rule: “At the same time, purchases under the new PEPP will be conducted in a flexible manner. This allows for fluctuations in the distribution of purchase flows over time, across asset classes and among jurisdictions” (ECB 2020a: para 3). This allows the ECB to focus on purchasing securities from those EMU-countries that have been hit hardest by the Covid-19 crisis, such as Italy, Spain or Greece. In addition, the quality of the collateral that the ECB must take into account in its asset purchases was further reduced. For example, claims of banks on small and medium-sized companies have since been accepted as collateral. In addition, it should be kept in mind that the ECB can use the instrument of outright monetary transactions (OMT), which was established in September 2012. This allows the ECB to buy an unlimited number of government securities from individual EMU member states on the secondary market, provided that these are subject to the requirements of the European Stability Mechanism (ESM) (see Chapters 9 and 10). In March 2020, as a further measure to contain the crisis, it was decided within the framework of European banking supervision, among other things, that the capital and liquidity buffers should be loosened. As a result, banks in the eurozone were granted capital relief of around €120 billion (ECB 2020d). The ECB, under its president Christine Lagarde, is obviously willing to continue the line of her predecessor Mario Draghi to defend the euro by unlimited interventions. When she was asked in an interview in May 2020 whether the ECB would, if necessary, go beyond the PEPP in its interventions, she replied: “On this topic, we have been very clear and we continue to be very clear – we will not hesitate to adjust the size, duration and composition of the PEPP to the extent necessary. We will use all the necessary flexibility within our mandate. There is no psychological obstacle to our action” (ECB 2020c: para 24). With these measures, the ECB has joined the ranks of the world’s major central banks to counter the Covid-19 crisis. The Fed reacted with even greater interventions to the crisis than the ECB. After the Fed’s refinancing rate, the effective federal fund rate, had been slowly increased from around zero from the beginning of 2016 to 2.4 per cent at the beginning of 2019 and remained there, it was lowered from July of the same year, initially moderately and then quickly, to close to zero, at the beginning of 2020 due to the economic slowdown. At the same time, the Fed implemented various programmes to help the financial system. The stock of government securities, and also private sector bonds, was massively increased. The Fed’s provision of US dollars to foreign central banks under swap agreements also exploded. Before the Covid-19 crisis, Canada, the UK, Japan, the euro area, and Switzerland had access to dollar liquidity. On 19 March, the Federal Reserve opened additional swap lines with Singapore, South Korea, Brazil, Sweden, Australia, New Zealand, Mexico, Norway and

Denmark. By Spring 2020, the use of swaps had already reached a level close to the maximum volume during the onset of the Great Recession at the end of 2008. The Fed’s balance sheet total had risen from 5 per cent of GDP in 2007 to over 20 per cent in 2014 and had been slowly declining thereafter. But already in the first few months of 2020 it climbed to values of over 40 per cent of GDP and is likely to rise even further. The Fed’s total assets doubled between mid-2019 and the end of May 2020 (see McCrory & Messer 2020). Not surprisingly, the ECB’s monetary policy is not without controversy in Germany, with criticism reaching far into the established political parties and the German economics profession. The German Federal Constitutional Court has been called upon to intervene. The complainants, who appealed to the Court, include Peter Gauweiler, the right-wing nationalist former politician of the Christian Social Union (CSU), Bernd Lucke, the founder of the National Alternative for Germany (AfD), a party that is clearly to the right of the Christian Democratic Union (CDU) and against the EMU, and the entrepreneur Heinrich Weiss, a financier of the AfD. They justified this move by claiming that the PSPP was a covert way of financing public budgets by the ECB and that this was unconstitutional. On 5 May 2020, the Court handed down its ruling (BVerfG 2020). It stated that programmes such as the PSPP were in principle possible, but that a proportionality test had to be carried out and the ECB would not have provided such a test. Therefore, it had to be delivered subsequently. Otherwise, Germany would no longer be allowed to participate in the programme. The German Constitutional Court thus contradicted the European Court of Justice, which on 11 December 2018 had considered the ECB’s monetary policy to be fully constitutional. The reasoning of the German Court is interesting, as it reflects the opinion of many German economists, experts and politicians. According to this view, the ECB’s purchases of government bonds reduce the pressure on southern European EMU countries to consolidate their budgets. Moreover, especially in these countries, this would keep companies in business that are not viable in the long term. At the same time, it would punish German savers with interest rates of zero and damage the profits of German banks and insurance companies. Ultimately, this would fuel the German real estate market. According to the Court, these problems would have to be taken into consideration in the ECB’s interventions and explained as to why the interventions had to be carried out despite the potential detrimental consequences to the German wealth-owner. The ECB reacted to the judgement by declaring the German Constitutional Court not competent in the matter and that the European Court of Justice has offered clarification. What will happen next? The German Bundesbank and the ECB could write a letter with a concise justification for PSPP as a matter of form. Or they could simply ignore the ruling. Presumably the decision of the German Constitutional Court will not have any serious consequences, but it shows that political majorities can be mustered in Germany and other countries that could block a joint stabilization of the EMU.

Country-specific fiscal crisis management As in the Great Recession, Europe reacted in terms of fiscal policy initially at the national level. Covid-19 hit countries in Europe differently. This is also reflected in different budget deficits, which the ECo (2020b) expects for 2020 and which include active fiscal measures and endogenous increases of budget deficits, mainly caused by collapsing tax revenues. They amount to 8.3 per cent of GDP for the EU as a whole and 8.5 per cent for the EMU. Italy is particularly hard hit with 11.1 per cent, Spain with 10.1 per cent and France with 9.9 per cent. Germany has an expected deficit of 7 per cent of GDP, compared with an astonishing 17.8 per cent for the United States. However, this expected development must be considered in the context of some countries in the eurozone already facing very high levels of public debt. In Greece debt stood at 181 per cent at the end of 2019, in Italy at 135 per cent, in Portugal at 122 per cent, and in Spain and France at 98 per cent. The figures for the EMU as a whole were 86 per cent at the end of 2019, 62 per cent in Germany and 106 per cent in the US (Trading Economics 2020). In view of the massive budget deficits the public debt situation is likely to continue to deteriorate dramatically in some countries. The active fiscal stimulus measures in Germany are by far the biggest. There has been no hesitation to intervene and the debt brake seems to have been forgotten. Anderson et al. (2020) have calculated the active fiscal impulse (such as additional government spending and the cancellation of certain taxes) and deferrals (deferment of certain payments, taxes etc., which in principle should be paid back later) and other liquidity guarantees shown in Table 13.1. Table 13.1 Levels of fiscal impulse and deferrals/liquidity guarantees adopted in response to the Covid-19 crisis by 15 June 2020 (% of 2019 GDP) Country Impulse Deferral Germany 13.3 31.6 The Netherlands 3.7 11.3 France 3.6 22.9 Portugal 2.5 16.6 Spain 2.3 10.0 Belgium 1.4 26.7 Italy 0.9 45.3 Greece 1.1 3.3 UK 4.8 17.7 USA 9.1 5.6 Source: Anderson et al. (2020).

The example of Germany can be used to show how these programmes are designed. The German federal government adopted measures affecting the budget totalling €353.3 billion and guarantees totalling €819.7 billion by June 2020, although not all of these measures will have an impact on expenditure as early as 2020 (BMF 2020). With regard to the guarantees, it is not yet possible to predict the extent to which they will lead to actual expenditure. The sum of €50 billion is earmarked as emergency aid for small enterprises and self-employed. From the new Economic Stabilization Fund, €400 billion will be guaranteed for ailing corporations, €100 billion will be used to finance direct state help for companies, such as the €9 billion stake in the airline Lufthansa, and another €100 billion will be used by the German government to finance the programmes of the federal development bank KfW (Kreditanstalt für Wiederaufbau).1 In June 2020, Germany launched a further economic stimulus package of €130 billion. The most important points in this package are a six-month reduction in value added tax (from 19 per cent to 16 per cent), a one-off payment of €300 per child, a doubling of the existing purchase premium to €6,000 per electric car and financial support for local communities. Finally, research is being promoted in specific areas and measures have been adopted in favour of industries that have been particularly affected by the crisis (Reuters 2020). Overall it is evident that the countries in the EMU hit hardest by the pandemic, such as Italy, Greece or Spain, have only pursued a moderate national fiscal policy response in comparison to Germany. Obviously the room for national fiscal policy in these countries is considerably smaller than in Germany. A warning was that with the Covid-19 crisis secondary market yields for long-term government bonds increased slightly in southern European EMU-countries.2 Of course, with PEPP and other programmes the ECB can keep interest rates low. But in countries like Germany and some northern European countries this would be most likely a source of political conflict, inside the countries and between them, if the ECB were to passively finance escalating deficits in countries with high public debt. An alternative for high budget deficits in countries like Italy and Greece would be a common fiscal policy for the EMU, which would benefit these countries.

Fiscal policy in the EU In marked contrast to the ECB’s decisive action, there were no relevant joint fiscal actions at EU or EMU level during the first phase of the Covid-19 crisis. This was in violation of the Treaty on the Functioning of the European Union (2020: Article 222): “The Union and its Member States shall act jointly in a spirit of solidarity if a Member State is the object of a terrorist attack or the victim of a natural or man-made disaster. The Union shall mobilise all the instruments at its disposal …”. Under the pressure of economic developments, ECOFIN decided on 23 March 2020 to

temporarily suspend the debt brake anchored in the Stability and Growth Pact (SGP), so that the EMU member states could take on more debt. After tough negotiations, the finance ministers agreed a joint financial package on 24 April 2020 for all EU countries of €540 billion, or 3.9 per cent of the EU GDP of 2019. The package was allocated to three areas. First, €240 billion are earmarked for loans under the European Stability Mechanism (ESM), which is allowed to provide credits if debtor countries follow the conditions decided by the ESM (in substance the Eurogroup) (see Chapter 11). These loans – unlike in the case of previous ones for example to Greece – are subject to only minor conditions, but the money has to be spent on direct and indirect healthcare matters. Second, a guarantee fund of €200 billion is to be set up at the European Investment Bank (EIB) to help small and medium-sized enterprises in the EU to obtain financing. To this end, the EU member states will deposit an additional €25 billion as a guarantee in proportion to their share of the EIB’s capital, with the help of which the EIB will then be able to mobilize the €200 billion by borrowing. Thirdly and finally, the support to mitigate unemployment risks in an emergency (SURE) programme, with a fund of €100 billion, was approved. This programme is intended to provide member states with credit for labour market policy measures, especially for expenditure on temporary reduced hours compensations. For this purpose, the ECo is taking on debt, with the EU countries guaranteeing it according to their share of the EU’s gross domestic income. Financing via “corona bonds”, on the other hand, was rejected (European Council 2020a). In the face of severe recession in 2020, this aid was welcomed, but it was still not sufficient compared to the challenges. This aid was provided in the form of loans, which means that the debt problems in the worst-affected countries will become even more acute. Demands for joint indebtedness in the EMU or EU became louder. Shortly after the €540 billion package was agreed, the heads of state of Italy, France, Belgium, Greece, Portugal, Spain, Ireland, Slovenia and Luxembourg demanded: “We need to work on a common debt instrument issued by a European institution to raise funds on the market on the same basis and to the benefits of all Member States” (CNBC 2020: para 9). This put the issue of euro bonds back on the table. In order to soften the expected resistance of Germany and its allies, the southern European countries emphasized that this should be a one-off measure appropriate to the crisis. For this reason, the joint debt should be handled under the name of “corona bonds”. Nonetheless, Germany and the so-called “frugal four” (Austria, Denmark, Sweden and the Netherlands) maintained their strict rejection of joint borrowing by the EU or EMU, regardless of its labelling. The intransigence of Germany and its allies led to fierce indignation and consternation in some of the EMU countries. Jacques Delors, a former European Commission president, warned that the lack of solidarity posed “a mortal danger to the European Union” and Enrico Letta, a former prime minister of Italy, saw for the EU a “deadly risk”. In a survey conducted in early April, 88 per cent of Italians said

they felt that they were abandoned by Europe and 67 per cent even thought that EU membership was detrimental to them (Guardian 2020). But then, much to the surprise of the German public in particular, Germany underwent a volte-face. On 18 May 2020, Chancellor Angela Merkel, and President Emmanuel Macron, jointly presented a proposal to support EU economies to the tune of €500 billion. The money should be borrowed by the ECo and distributed in the form of grants to those countries hardest hit by the crisis. This €500 billion is thought to be in addition to the €540 billion provided for in the ECOFIN programme. The Merkel–Macron plan provides for joint borrowing by all EU countries. This is close to the logic of corona bonds or euro bonds. Formally, the difference is that euro bonds are jointly and severally liable, so that Germany, for example, would have to step in for another country if it failed to meet its payment obligations. When ECo takes out a loan, it is not jointly and severally liable, but the loans taken out are secured by the EU countries in accordance with their size and economic strength. If a country defaults on repayment, the ECo and not, to stay with the example, Germany must pay for it. In practice, this small difference is insignificant as the ECo in such a case has to raise money from member states. But the opponents of euro bonds were able to announce in public that there would still be no joint and several liabilities. Aside from this rather ideological battle, Merkel and Macron obviously realized that without a joint commitment the existence of the EMU and EU would be at risk. The joint announcement also supported the idea of a European industrial policy and the strengthening of European companies in strategic sectors (Frankfurter Allgemeine 2020). A short time later, on 26 May 2020, and in line with the Merkel–Macron proposal, the German president of the ECo, Ursula von der Leyen, presented a €750 billion programme to be managed by the ECo (Zeit Online 2020). The ECo would take out loans to this amount as a joint debt of the EU countries, of which €500 billion would be handed in the form of grants and €250 billion as loans to the member states for reconstruction. The debts are to be repaid by 2058. According to current plans, almost €173 billion would go to Italy and €140 billion to Spain, but only about €29 billion to Germany. In addition, according to the proposal the EU budget is to be increased in the coming years. A digital tax, financial market tax and CO2 tax have also been discussed. Such a development would significantly increase the power of the ECo and thus also of the European Parliament. In July 2020 after difficult negotiations the European Council reached a compromise. The post-coronavirus recovery package of €750 billion is divided into €390 billion as grants and €360 billion as low-interest loans to member states. It includes checks that the funds will not be misused. Recipients will have to submit spending plans to the ECo, and a majority of states will be able to block projects. However, part of the compromise was that the budget of the ECo for the next seven years, from 2021 and 2027, remains around 1 per cent of the EU’s GDP. Funds for research and other important areas for the future of the EU were even cut

which led to broad criticism by the European Parliament. It looks like that the recovery package does not lead in the medium term to an increasing importance of the ECo’s budget including a fiscal policy function.

Covid-19 crisis and the high risks for the European Monetary Union Despite the diverse fiscal responses to the Covid-19 crisis and the policies of the ECB, the ECo and other institutions, the EU and especially the EMU are facing major risks in the coming years. These are concentrated around three danger areas known from other deep and persistent crises such as the Great Depression: (1) falling nominal wages and deflation; (2) high debt stocks which prevent a recovery; and (3) the lack of medium-term sufficient fiscal stimulation (Dodik & Herr 2014). We shall discuss each risk in turn. In the EMU there has been a long-term trend of weaker trade unions based on decreasing union membership, labour market deregulations and a hostile political climate. The sharply increasing unemployment rates in the EMU will most likely further reduce the bargaining power of trade unions and workers. This can put pressure on labour markets to such an extent that nominal wages, and with them wage costs, decrease. If unit labour costs decrease, prices will decrease and the country falls into a deflationary spiral (Keynes 1930). This risk is increased as a number of mainstream economists consider wage cuts as a remedy against high unemployment. The microeconomic logic suggests that wage cuts can help firms in a crisis to survive. A good example of deflation is the 1930s Great Depression. At that time, in almost all industrial countries, falling nominal wage levels led to a cumulative deflation. Japan after the mid-1990s is a second example of this pattern. Moderately falling wage costs kept Japan in a deflationary constellation, which substantially contributed to the long-term stagnation of the country, which has not yet been overcome. The ECo (2020b) expects an inflation rate of 0.2 per cent in the EMU in 2020, and price levels to fall in some member states.3 The combination of insufficient demand leading to demand deflation and falling labour costs does not bode well for the EMU in terms of price level development. In 2014 the oil price, which reflects the price development of many commodities, plummeted from almost $100 per barrel to around $40. It then rose moderately to over $60, only to fall again to a level of around $40 in 2020 (Trading Economics 2020). Such a development puts additional pressure on prices. Wage-dumping strategies of EMU-member countries cannot be excluded from the problem. It has been shown that Germany, which has not experienced a longer-term severe economic crisis for a long time, created big problems for the EMU because of its low wage increases (see especially Chapter 7). This must be considered in the context of an absence of joint wage negotiations, there is no joint minimum wage and no joint social security in the EMU. Due to the lack of common institutions in the labour market, the euro area is

particularly vulnerable to deflationary developments. In the many measures discussed in the EMU at national and international level, the need to defend a nominal wage anchor for price levels is completely absent. But wage increases in all EMU-countries, according to the country specific productivity growth trends plus the target inflation rate of the ECB, are essential to prevent braking the nominal wage anchor. This leads to the problems of deflation. What company would buy a machine now when it expects that a competitor will be able to buy the same machine for less in a year’s time? A wage cut not only makes it harder for households to pay back mortgages or other debt, it also reduces consumption. But the main point is that deflation increases the real debt burden. During deflation, nominal debt services do not decrease but revenues do. The outcomes are widespread financial problems, stagnation or even cumulative shrinking of the economy (Fisher 1933). Sharp recessions, such as the Covid-19 crisis, even without deflation almost automatically lead to liquidity problems and problems of high debt in the private sector. When revenues shrink many firms are unable to service their debt, pay their suppliers or pay wages. Similar developments affect private households which become over-indebted. Following the logic of markets, financial institutions will stop giving credit to units in financial problems as they do not want to throw good money after bad. Strict credit rationing is the result. At the same time companies and households with high stocks of debt reduce credit demand and try to cut spending. In such a situation, the central bank has to take over the function of a lender of last resort and governments have to take over guarantees for financial institutions and other economic units or even nationalize them. Without such comprehensive intervention the 2007/08 financial crisis and the following Great Recession would have led to the same disaster as the Great Depression in the 1930s. In the Covid-19 recession the ECB assumes its function as lender of last resort. And national governments act as guarantors for companies and financial institutions. But there is a further related problem. One of the key problems of severe recessions is that they inevitably lead to high stocks of non-performing loans (NPLs) and debt levels in general which choke recovery. High stocks of debt and especially high NPLs block credit expansion and GDP growth. It was Hyman Minsky (1975) who analysed the fact that after phases of increasing debt quotas, expectations and animal spirits of creditors and borrowers can remain poor for a long time and de-leveraging is a painstaking process. This was again confirmed in a comprehensive empirical study of 88 financial market crises in 78 countries since 1990: NPLs are “associated with depressed output and thus slower economic recovery” (Ari et al. 2020: 3). Compared to the financial market crisis of 2007/08, banks had higher capital ratios at the beginning of the Covid-19 crisis, but public debt ratios were significantly higher, banks were less profitable and the corporate sector was less stable (Ari et al. 2020). If the postcrisis recovery is weak, the corporate sector in many EMU countries could face serious

problems, and NPL problems could accumulate and trigger another banking crisis (Ari et al. 2020a). In fact, private debt levels as a percentage of GDP have been rising steadily for years and make the overall economic constellation very fragile (see Table 13.2). Table 13.2 Private debt in selected EMU countries (% of GDP) Country 1995 2007 2018 France 164 203 266 Germany 149 162 154 Greece 49 115 128 Italy 123 167 165 Portugal 160 278 247 Spain 129 276 198 Source: OECD (2020).

At the end of 2018 the debt ratio of companies in the EMU was 77 per cent of GDP and that of private households 106 per cent of GDP (ECB 2020f). It can be seen that in many EMU countries, apart from Spain, debt levels hardly reduced at all after the financial crisis in 2007/08. In addition, although NPLs were significantly reduced after the Great Recession, some countries still suffer heavily from such loans. According to the ECB (2020f: 68) the non-performing loan ratio4 in Greece was 35 per cent at the end of 2019, i.e. more than a third of the loans were non-performing. In Cyprus the figure was 17 per cent, in Portugal 7.1 per cent and in Italy 6.7 per cent. By comparison, the percentage was 2.5 per cent in France and 1.2 per cent in Germany. Overall, NPLs amounted to 4.2 per cent of eurozone GDP before the Covid-19 crisis. There is a risk that after the Covid-19 recession has passed, private sector debt ratios and NPLs will be even higher and continue to rise. And in all likelihood there will be no political will to reduce quickly the balance sheets of companies and financial institutions of NPLs as well as the over-indebtedness of private households. The consequence would be that the credit-investment-income-creation process would not get off the ground and the EMU enters a Japanese scenario with low growth rates in the long run. If deflationary tendencies are then added to this, the NPL problem will become even worse. Japan is a good example of the consequences of protracted private sector over-indebtedness problems (Herr & Kazandziska 2011). The solutions of NPL problems is certainly not easy, as they imply distribution conflicts and ideological disputes. If the banks are capitalized, the taxpayer has to pay for it; if some bank deposits are cut, as in the case of the restructuring of banks in Cyprus after the financial market crisis, depositors are affected; if a bank is nationalized, the owners lose out. In the EMU, the problem is exacerbated by the fact that after the Covid-19 crisis NPLs are likely to be concentrated in individual countries which are anyway weak. A joint

restructuring would be necessary by strengthening the Single Resolution Board and Single Resolution Fund within the framework of the European Banking Union (see Chapter 12).5 The final challenge is the need to stimulate demand in the medium term. Not only is it necessary to pursue an active fiscal policy during the crisis itself, but a strong and long-term stabilization of demand is needed. The best option seems to be a long-term-oriented global “Green Deal” with massive public and private investment to support ecological transformation. Charles Wyplosz (2020: 28) puts this in a nutshell: “Governments should be very careful not to undermine the resumption of growth as they feel the urge to wind down the deficits that they opened up during the crisis. The now classic example is the euro area’s double dip after the Great Recession.” The scope for expansionary fiscal policy is high in the current situation thanks to low interest rates. Paul Krugman (2020) gives an example. If a public debt ratio of 100 per cent is assumed, a permanent primary budget deficit (i.e. deficit excluding interest payments) of 2 per cent, a nominal growth rate of 4 per cent and a nominal interest rate of 2 per cent (i.e. a real interest rate of zero), then the public debt ratio remains at 100 per cent. If in this situation an additional public permanent investment programme of 2 per cent of GDP is introduced, the public debt will increase in the long term. In 2040, a public debt ratio of 133 per cent would be reached, and in 2055 of 150 per cent. Now, the assumptions of a long-term real interest rate of zero and sustained real growth of 2 per cent are optimistic, but interest rates will probably remain very low for a long time and a real growth rate of 2 per cent does not seem impossible. Such scenarios should be viewed in the context of a monetary policy that has lost its power to stimulate the economy and when fiscal policy is needed to prevent a catastrophic development. In the longer term, government debt can be limited by appropriate taxation. The danger is that once the Covid-19 recession is over, EMU countries will be encouraged to reduce their budget deficits quickly. The German finance minister, Olaf Scholz, has already called for a start to be made on debt repayment of credits taken by the ECo (Berliner Zeitung 2020). In the EMU it is not only the fact that neoclassically oriented economists and politicians have an aversion to active fiscal policy and switch to austerity as soon as the first signs of a recovery can be seen. In addition, attention is paid to the moral hazard problem, which says that individual EMU member states can be irresponsibly running high and persistent budget deficits in the hope that they are bailed out by others or the ECB. The best policy against these arguments is to conduct active fiscal policy at the central EMU level which can be controlled by all member states and the European Parliament. The Covid-19 crisis offers an opportunity to push the EMU integration process towards a fiscal union with an EMU Treasury that generates its own tax revenues, is allowed to follow active fiscal policy and can get into debt. The ECo would mutate into a government, which would have to be controlled by the European Parliament. The European Council would thus

become a second chamber at supranational level. Germany’s paradigm shift towards a common European debt is a first hopeful step. But it must remain open whether this will trigger further steps towards integration. The economic impact of the Covid-19 crisis will be severe for the EU and the euro area. The burden of the crisis will be distributed very unevenly among the individual member states. It is also expected that different countries will emerge from the Covid-19 recession at different speeds. The economically more stable countries should cope better with the crisis than the economically weaker ones. It takes little imagination to see that after the Covid-19 recession high levels of private and public debt ratios, different budget deficits and different wage developments can create the potential for conflict. This can further strengthen the break-up forces in the EMU and EU, which were already present before the pandemic. The ECB alone will not be able to hold the EMU together in the long term. Thus, the Covid-19 crisis could act both as an accelerator and as an explosive force for integration in the EMU.

14 PROSPECTS FOR EUROPEAN MONETARY POLICY AND EMU

The EMU with the introduction of the euro has been a far-reaching step for European integration. Such steps usually do not happen without fundamental political breaks like wars. In Europe, the integration was peaceful and driven by the motivation to create a stable framework for economic prosperity and to help strengthen Europe’s voice in an evolving more multipolar world. Unfortunately, the EMU still has not been able to create a monetary union that is resilient against internal and/or external shocks. The Great Financial Crisis and the following Great Recession hit the EMU without sufficient institutional and political structures to cope with such crises. Looking at the development from 2008 until early 2020, the conclusion that must be drawn is that the management of the crisis was poor, for example, when compared with the United States, and not approached with theoretically ideal policies. The economic, social and political costs of the poor crisis management in the EMU were high, especially in the countries which had to follow policies of the Troika or which implemented such policies to avoid the Troika. One can speak of a lost decade in a number of EMU countries and in the whole EMU of a development towards more inequality, more precarious jobs and more political polarization. Crisis developments led to a number of positive integration steps in the EMU, for example, an EMU-wide banking supervision at the ECB, but in other areas progress was poor. It is worrisome that in the EMU the crisis after 2008 has not yet been overcome; refinancing rates of the ECB in early 2020 are still zero and quantitative easing is still in place. But the ECB should not be blamed. As the only powerful supranational EMU institution, it was pushed into a position in which it took over stabilizing functions for the EMU and made policies which went far beyond the mandate it was given. In early 2020 Europe was hit by the Covid-19 crisis which developed into the deepest recession since the Second World War. As with all crises, the Covid-19 crisis provides an opportunity for big structural changes. The pressure of the crisis may lead to substantial further integration steps in the EMU, but also potentially in the EU. But it also has the potential to break the EMU and substantially weaken the EU. The risk of disintegration will increase if countries recover from the crisis differently and if there is a lack of demonstrable solidarity from stronger countries.

In this final chapter, we first discuss the main problems and potential solutions for the EMU in more detail. We also discuss that in spite of all the problems given, dissolution of the EMU would be very problematic.

The central problem: monetary union without statehood Over the preceding chapters, the central problem of the monetary union created in Europe in 1999 has become clear: although the introduction of EMU established a common currency area and a central bank as a supranational institution, in all other areas at the supranational level it is missing the vital institutions for the macroeconomic management of a monetary union. The EMU is comparable to a half-finished house in the process of extension. The various owners of the house have decided to remove the outer walls to make the house bigger and are now at the mercy of the weather. However, apart from the roof, the ECB, they have no common plan on how to make the house weatherproof again. The experiment of the EMU has shown that the creation of a monetary union without a sufficient transfer of power to supranational structures creates an unstable economic constellation. It is illusory to believe that monetary policy can function as the only macroeconomic policy to stabilize macroeconomic development and keep a currency area stable. Capitalist economies are inherently unstable and need permanent macroeconomic management with a whole set of institutions and policies. Europe has been paying the price for the fact that the United States of Europe, in whatever form, was not considered necessary in the Maastricht Treaty, which in the early 1990s laid down the structure of the EMU. To have something like the United States of Europe was not at all consensual at that time and is still not consensual today. The designers of the EMU in the 1990s were obviously not able to realize what an unstable structure they were building or they hoped that the pressure of the real world would later lead to sufficient integration. The European Council and the Eurogroup emerged as the political power centre of the EMU. These assemblies of state leaders and finance ministers decide on all important economic (and political) issues from the perspective of national interests. Decisions have to be taken unanimously or with complicated majority rules. The ECo has not been able to develop into a kind of EU or EMU government, just as the European Parliament has not become the sovereign of the EMU or EU. In many areas, the structures of the EU and the EMU are intermingled. Although the EMU has achieved deeper integration than the EU, there is no clear strategy for a multispeed Europe or a clear plan to integrate the EMU countries more deeply and rapidly than the EU countries. Substantial deeper integration in the EU is more difficult than in the EMU, and for creating stability, also not needed. For this reason, we recommend a Europe of different speeds, a clear separation of policies of the EMU and EU and a rapid further integration of the EMU.

Economic policy cooperation between the EMU member states could have at least partially compensated for the lack of statehood in the EMU. However, the interests of member states were often too diverse to pull together. Germany, the largest economy in the EMU and after 2009 in a comparatively stable constellation was not prepared to assume responsibility for the entire EMU or lead policy in the interest of the whole EMU. Although Germany occupies a hegemonic position due to its economic strength and political influence, it is a weak hegemon. Within the EMU, Germany cannot act independently of the political orientations of the other member states, especially France. And its economic strength is not sufficient to dictate policies. Consequently, Germany remains focused on its own national interests. The consequence is similar to the famous prisoner’s dilemma: cooperation would be better for all countries, but national egoism prevents sufficient cooperation – with a suboptimal result. However, the losses were distributed among the different EMU countries in extremely different ways. At the end of 2019 there were signs of an economic slowdown in the EMU. Then in 2020 the Covid-19 pandemic hit the EMU and led to a recession. All signs point to a slow recovery from the Covid-19 recession and a prolonged period of low growth. At the same time, the southern European countries, in particular, were not yet on a stable growth path before the Covid-19 crisis hit. The situation is exacerbated by the fact that the ECB has shot most of its powder in the fight against past crises. The refinancing rate of the ECB has been zero for years. The credit-investment mechanism in the EMU did not recover sufficiently as banks are reluctant to lend and companies are cautious in their investment activities. Although the rapidly increasing liquidity that the ECB began to pump into the financial system in 2020 and its massive purchases of public and also private debt securities relieves the burden on public budgets in refinancing their debts and thus facilitates their budget planning, the growth effects of the super-expansionary monetary policy are small. In contrast, the negative sideeffects of the ongoing expansionary monetary policy are increasingly intensifying. First of all, the zero interest-rate policy and overflowing liquidity encourages overvaluation in asset markets, especially in the stock and real estate market. For example, in real estate markets, this led to substantially higher rents in Germany, increased income inequality and intensified social distortions. Stock prices remained high in Spring 2020, despite the Covid-19 crisis. The danger of a renewed crisis in asset markets with its negative effects on the financial and real economy hovers over the EMU like the sword of Damocles. The policies in the EMU to handle the 2009 Great Recession and its effects on the EMU were wanting and did not draw lessons from past deep economic crises, such as the Great Depression in the 1930s or the long-term stagnation in Japan since the 1990s (Dodig & Herr 2015). In summary:

• Only since 2012 has the ECB been allowed to act as lender of last resort for public households. • Macroeconomic stimulation of demand was insufficient. The ECB made the mistakes of increasing interest rates in 2008 and 2011, but overall followed expansionary monetary policy, which cannot be criticized. Fiscal stimulation was insufficient or missing. The EMU followed a largely uncoordinated fiscal expansion in 2009, but stopped active expansionary fiscal policy in 2010 – which was much too early. The fiscal centre in the EMU is too small and powerless to implement anticyclical fiscal policy, to harmonize the tax system in the EMU or to carry out an EMU- or EU-wide infrastructure policy or industrial policy in general. The 2020 Covid-19 recession led to a change in European fiscal orientation, particularly in Germany. Joint borrowing by all EMU and EU countries was carried out by the ECo and transferred in part to the crisis hit countries such as Italy and Spain. A European “Green Deal” is planned. However, whether joint borrowing by the ECo is a single event, and whether joint or coordinated fiscal stimulation in Europe remains strong and is of a duration that overcomes the danger of a longer-term period of low growth, has yet to be seen. • Balance sheets of banks were not sufficiently cleaned in the EMU-countries most severely hit by the crisis. Non-performing loans remained high in some countries and hindered the re-establishment of a credit-investment-income-creation mechanism. It remains unclear how the problem of high public debt of some countries, usually correlated with high nonperforming loans in the financial and enterprise sector, will be solved. The Covid-19 crisis has the potential to dramatically increase this problem. In addition, other elements of a banking union are incomplete. In particular, sufficient EMU-wide deposit insurance is missing. • After the Great Recession wage development in some of the EMU-countries was deflationary with decreasing nominal unit labour costs and a too low or zero inflation rate. This added to the non-performing loan problem. Wage coordination in the EMU does not take place. The Covid-19 crisis has the potential to push the EMU into a deflationary constellation comparable with Japan or even worse. Against this background of the structural weaknesses of the EMU, the obvious inability of the EMU in the past to follow functional economic policy, and the challenges presented by the Covid-19 crisis, it would be necessary to take rapid and substantial steps towards further integration within the EMU. However, neither national governments nor the majority of the electorate in the EMU and even less in the EU are willing to transfer relevant sovereign rights to the central level. Any clear step towards European state-building would further intensify the already strong polarization in the EU countries and give a further boost to radical right-wing parties in particular. Today there is hardly an election campaign in the

member states of the EU in which right-wing parties, in particular, do not try to gain additional votes by insisting on national sovereignty. Unfortunately, Germany has undoubtedly contributed to the disenchantment with Europe in parts of the EMU through its policy in the Troika and its condescension. The possibility of countries leaving the EU or even the EMU, similar to Brexit, cannot be ruled out in the future. The Covid-19 crisis is a chance for the EMU to push for further integration. In what follows, key reform areas are briefly discussed.

Improvements of monetary policy In spite of the overall positive evaluation of ECB’s monetary policy after 2012 there are some changes in the monetary policy strategy which would improve the ECB’s performance and the EU’s macroeconomic management (see also Stiglitz 2020: 81ff.). First, the ECB should switch to the medium-term inflation target of 2 per cent and not the unclear target of close to but below 2 per cent. The 2 per cent should be a symmetrical target without a bias to have an inflation rate below 2 per cent. Second, an important point is that for the inflation target the ECB should follow the Fed and choose the core inflation rate and not the consumer price index as its medium-term inflation target. Core inflation rate as a target has the advantage that a central bank has not to react to volatile energy and food prices. A mediumterm target, followed by the ECB, also allows flexibility for monetary policy in case of price shocks, but a core inflation target is clearer. These two points can be immediately changed as the ECB alone decides its inflation target. A third point is more difficult to change. The ECB should switch back to traditional monetary policy which had not only an official inflation target, but also targets like GDP growth and employment. For such a change the constitution of the ECB has to be changed.

EMU finance ministry As we have repeatedly stressed, without a supranational fiscal institution as an important macroeconomic partner, the ECB cannot function well. What is needed is an EMU finance ministry with the rights of direct European taxes. For example, a certain percentage of the value-added tax or a newly created financial transaction tax could directly go to the EMU finance ministry. Certain functions currently under national control could be transferred to the EMU level. Examples are expenditures for infrastructure or research for climate protection. To a limited extent, a monetary union should also be a transfer union with the aim of creating the same living standards in all parts of the monetary union in the long run. An EMU finance ministry should also be entitled to issue euro bonds with a joint liability of all EMU-countries and carry out active fiscal policy. The ECB would have to guarantee the

liquidity and solvency of such bonds, as is customary in every nation state. Such a step would have to be combined with a powerful European Parliament controlling the finance ministry. There are numerous proposals on how euro bonds could be designed in concrete terms and how moral hazard problems could be controlled (Brunnermeier et al. 2016; Bibow 2019). For example, as a start euro bonds could be used exclusively for financing public investment and the amount of bonds issued could be limited to a certain percentage of the EMU’s GDP. The railway system could be expanded and modernized throughout Europe, which is necessary to combat climate change. Other examples are the energetic modernization of the building stock, the urgently needed refurbishment of the educational infrastructure or the promotion of sustainable energy sources. Such a future-oriented structural policy could be embedded in a Europe-wide industrial policy within the framework of a Green New Deal, which gradually restructures the economies in an ecological direction. To issue euro bonds has long been called for by the ECo, among others. In 2008 JeanClaude Juncker, at that time president of the Eurogroup, suggested: “The EU Commission could issue euro bonds and spend the money especially for example for roads, the railway network or the energy system” (Euractiv 2008: para 2). However, the idea was rejected by a majority of the European Council on several occasions. In particular, Germany, France, Austria and the Netherlands were strongly opposed to euro bonds for the budget of the ECo (Spiegel 2010a). The European Stability Mechanism (ESM) issues bonds to support governments. The German finance ministry makes clear: “ESM-bonds serve the financing of ESM credits to ESM-supported countries … Germany is basically only liable according to its share on the capital of the ESM … euro bonds are fundamentally rejected by the German government as they would imply a complete communization of debt without any return for it” (BMF 2017: para 51). The Covid-19 crisis has brought some movement in this debate. Germany and France are now in favour of borrowing by the ECo more or less following the logic of ESM-bonds. But such joint borrowing is planned as a one-time measure because of the Covid-19 pandemic. The SGP with all its amendments including controls, threats and sanctions cannot replace a European fiscal policy. On the contrary, because of the regulations geared towards preventing active short-run and long-run fiscal policy, the fiscal rules in the EMU hinder growth-supporting fiscal policy and leave the ECB as the supranational institution stabilizing the EMU alone. One way to give more room to fiscal policy on a national level would be to (re-)introduce the “golden rule of fiscal policy”. Numerous econometric studies (Truger 2017) confirm the positive growth impetus of such a policy. If, for example, only the four large EU countries, Germany, France, Italy and Spain, had followed the “golden fiscal rule” from 2011 until 2017 instead of the austerity policy they pursued, the entire eurozone would have achieved a 1.8 per cent higher increase in GDP in 2017 (Behrend et al. 2019: 15). Integral to a fiscal union in the EMU or even in the EU would be a harmonization of the

tax system and the elimination of tax havens also within the EMU. Taxes in different countries do not have to be identical, but there should be a band of tax rates and tax regulations which prevent the current tax dumping. Also elements of an EMU-wide social security system, for example, unemployment insurance, would add to a fiscal union. If a fiscal union is created with the right to raise taxes, issue euro bonds and also support regional public households, the ESM has to change its mission. It could take over the function of providing cheap finance for EMU (or EU) governments in specific situations – from natural disasters like earthquakes or pandemics, but supporting especially big infrastructure projects or ecological transformations.

Financial market regulation A Single Supervisory Mechanism for big banks located at the ECB as part of the European Banking Union (BU) is an important step towards integration in the financial system. This also applies to the newly created institutions for macroprudential supervision. Steps in the direction of a unified EMU-wide restructuring and winding-up mechanism for banks and the creation of a (small) fund as part of a Single Resolution Mechanism are also steps in the right direction. But despite these steps, the EMU banking system is not entirely in good shape. Banks in the eurozone are partly still sitting on large stocks of bad loans, which could not be reduced sufficiently during the last weak economic upswing. Non-performing loans are especially concentrated in southern Europe because of the poor economic development in these countries. These non-performing loan problems could escalate during the Covid-19 crisis. In dealing with bad loans, the EMU differs remarkably from the United States. In the US these loans were quickly outsourced to a bad bank and gradually restructured from there (WirtschaftsWoche 2019). In addition, the Fed bought much more toxic papers than the ECB. A positive example to combat a banking crisis can be found in Sweden, which suffered from non-performing loans in the early 1990s because of a large real estate bubble. The government gave a guarantee for all bank deposits and creditors of all Swedish banks. Shareholders had to accept losses. A bad bank was created which took over non-performing loans and state asset-management companies sold the assets to minimize losses. A number of banks were nationalized and later sold. The bailout initially cost around 4 per cent of Sweden’s GDP. After some years the nationalized banks were privatized and almost all costs could be covered (Dougherty 2008). In early 2017, Andrea Enria, chairman of the European Banking Authority, demanded an “EU ‘bad bank’ to buy billions of euros of toxic loans from lenders to break the vicious circle of falling profits, squeezed lending and weak economic growth” (Financial Times 2017: para 1). In the same interview, he suggested a taxpayer-backed EU-wide fund to buy bad loans

from struggling banks. And he correctly argued that in the EMU cleaning the balance sheets of banks after 2008 was even slower than in Japan in the 1990s after the end of the real estate and stock market bubble. The slow cleaning of banks’ balance sheets in addition to falling unit labour costs causing moderate deflation must be seen as a mature factor for the Japanese long-term stagnation (Herr & Kazandziska 2011). An EMU-wide method to clean banks’ balances after the Great Recession was not possible because the solution to the problem of bad loans remained with the respective member states which themselves were financially overburdened. Stronger countries showed no solidarity to solve the problem together and prevented a fund, demanded by Andrea Enria, to solve the non-performing loans problem. The ESM also could be used to restructure banks with large quantities of non-performing loans, but the ESM is not allowed to do this directly. An EMU-wide fund and a “bad bank” to solve the non-performing loans problem along the Swedish strategy is urgently needed. The nationalization of banks should also not be taboo nor should the winding-up of non-bank financial institutions. A great weakness of the BU is that it does not create an EMU deposit insurance scheme. This destabilizes capital flows within the EMU, sets weak banks under great pressure and destabilizes the EMU financial system. Germany and a number of other countries strictly refuse to agree to a European deposit guarantee. The reason for this refusal is the demand that countries with high non-performing loans first have to reduce risks in the banking sector on their own, before risks can be shared in the EMU. To improve financial system stability the BU has to be completed. Finally, the shadow banking system, international capital flows and the real estate sector remain under-regulated. But this is not only the case in Europe but also in almost every developed country. Steps towards more regulation in these fields are urgently needed.

Steps towards an EMU labour market Since the Great Recession, there has been no progress on labour market integration in the EMU. Wage formation mechanisms in the EMU member states are still exclusively national in character. It must be assumed that the persistence of these national structures has a long inertia and will continue for decades to come. Joint wage negotiations in the metal industry in Germany, France, Italy and the Benelux countries seem to be light-years away. If there has been a wage policy at EU level, it has been a programme to deregulate labour markets and weaken sectoral wage bargaining. The Troika, when it had the chance to dictate policies, pushed very hard towards such policies. One of the indicators of the macroeconomic imbalance procedure is the wage development in a country. But the indicator only looks at high wage increases. It is not part of the procedure when wage increases are too low or nominal wages even decrease. The danger of deflation in parts of the EMU is simply ignored

and the Covid-19 recession has the potential to push the EMU into serious deflation. Obviously there is no guarantee that wage developments in the EMU as a whole will be functional. For a currency area nominal wages should increase in line with trend productivity developments plus the central bank’s target inflation rate. This is likely to be the case only by chance in the EMU. In the course of the last decade, the ECB has failed to realize its inflation target because wage increases have been too low. There is also no guarantee that regional wage developments do not destabilize the EMU as they did before the Great Recession. Without sufficient institutions and active policies in the field of wage bargaining and labour markets, in the future regional wage developments may again occur in an incoherent way and create regional problems in the EMU. During the last decade, a number of EMU institutions have been reformed to reach certain cohesion. This has been not the case in the field of labour. It would be of great significance if the macroeconomic dialogue is strengthened to support the ECB in its monetary policy (Janssen 2017; Koll & Watt 2017). There is also no EMU minimum wage. To have the same minimum wage in the EMU is difficult as productivity levels in the different countries are too different. But certain regulations are possible. For example, that minimum wages in all EMU countries increase at least according to regional trend productivity development plus target inflation rate, or that regional minimum wages are not allowed to be lower than 50 per cent of median wages. An EMU minimum wage commission could be established to give recommendations as to how minimum wages in member states should develop. In all countries wage bargaining on a sectoral level should be supported, including extending wage bargaining outcomes to all employees in a sector. This increases the likelihood of coordinated wage development at least in one country. Joint wage negotiations of different countries should be supported as well. The public sector could take the lead. But also highly concentrated sectors like the metal or chemical industry could move to EMUwide wage bargaining. Common social dimensions are largely omitted in the EMU. Social security systems are anchored exclusively at the national level and are therefore subject to a wide variation. A first step towards integration in this field could be the introduction of EMU-wide unemployment insurance (Dullien 2015). This would not only be an expression of solidarity but would also have a fiscal stabilizing effect, as crisis regions would benefit from transfers from prospering regions. Generally speaking, the stability of a monetary union is enhanced if there is at least a minimum of transfer payments between regions that act as automatic stabilizers. In order not to burden workers in regions with low employment, such an insurance scheme should partly be financed by taxes.

Dissolution of the EMU is not a realistic option

Given that hardly any country in the EMU is prepared to surrender sovereign rights to supranational institutions, some Europeans experts are now also proposing that the crisis countries leave the EMU and the EMU should be at least partly dissolved (Scharpf 2017). They point out that in this case, the crisis countries could then use exchange rates as a weapon against a lack of competitiveness and against wage-dumping strategies of other countries like Germany. Moreover, the central banks, by introducing their own national currencies, would then be able to fulfil their role as lender of last resort also for public households without any concessions. Finally, fiscal policy would also escape the straitjacket of the SGP. We are sceptical about such proposals, although we too consider the current situation to be extremely fragile. First, the high inter-regional debt of the crisis countries within the EMU (see Table 7.1) is obviously denominated in euros. If these countries were to leave the EMU, these debt stocks would be fixed in a currency that would be foreign to them. The countries would be in the same position as many countries in Africa or South America struggling with high debt in foreign currency. The constellation would be exacerbated by the fact that the newly introduced currencies of these countries would undoubtedly have to be devalued drastically so that the real debts of the state and the private sector would rise sharply. A debt crisis would be inevitable without the possibility of the national central banks to act as lender of last resort. National bankruptcy and the collapse of many companies and private households could become a reality. An exit from the euro would be extremely expensive for these countries. We fully agree with Barry Eichengreen (2010: para 1) that the very announcement of leaving the euro area would trigger a deep financial market crisis: “Leaving would require lengthy preparations, which, given the anticipated devaluation, would trigger the mother of all financial crises. National households and firms would shift deposits to other eurozone banks producing a system-wide bank run. Investors, trying to escape, would create a bondmarket crisis.” Secondly, we do not believe in an independent national monetary policy just because a country has its own currency. If trust in national currencies is eroded, room for domestic oriented monetary policy shrinks (Cohen 1998). As we have shown in Chapter 2, devaluation expectations lead to capital flight, immediate sharp devaluations and the danger of devaluation-inflation spirals. In such a situation a central bank cannot stand idly by and watch. These market processes may force a central bank to adopt extremely restrictive monetary policy. This, in turn, reduces economic growth and employment. There is a high probability that countries leaving the EMU would suffer from such a constellation. Also if central banks in countries with weak currencies take over the function of lender of last resort for public households in an extensive way, the monetary wealth created in domestic currency will be quickly exchanged for foreign currency with the negative effects discussed.

Another question is whether countries that are not yet members of the eurozone should adopt the euro. We recommend that countries that have not yet adopted the euro should not join the EMU, at least not at present, because of its fragility and uncertain future.

The need for further integration The basic problem of the ECB, which has been a recurrent theme since the outbreak of the financial market crisis in Europe in 2007/08, is the lack of economic policy partners that make a joint macroeconomic management of the EMU possible. In its monetary policy, the ECB was driven by crisis developments in the EMU, not only during the Great Recession, but also during the weak recovery and the Covid-19 crisis. Many of the ECB’s problems were due to the lack of an EMU government including appropriate institutional actors. The ECB can be reproached for its strict insistence on its inflation target and its unwillingness to tolerate short-term violation of the target. For example, it was a clear mistake just before the Great Recession of 2009 and just before the second recession of 2011 to raise interest rates simply because inflation rates were above 2 per cent. But it should be noted that according to its statutes, the ECB has only to support growth and employment if the inflation target is achieved. The ECB should look to both growth and price level development. Independent of this criticism, the ECB has guaranteed the survival of the euro – especially from the time Mario Draghi became ECB president and the worsening crisis situation in 2012. In this sense the ECB became a very political central bank, taking over functions which should have been fulfilled by a government. There is no ideal or easy way out of the EMU’s institutional crisis. There is some hope from the fact that a certain degree of realism has prevailed in the past in the face of serious crises. For example, in the end, even Germany grudgingly stood still when the ECB assumed the role of lender of last resort for public budgets in 2012 and in 2020 demanded joint borrowing of EU countries via the ECo. In this respect, there is likely to be a muddling through in day-to-day politics in the future as well, so that the euro is kept alive. After the Great Recession, there have been steps towards stronger central institutions, for example, the ESM and the BU. This slow process towards further integration may be speeded up by the Covid-19 crisis. At least we hope so.

NOTES 1

Introduction: European integration

1. In 1973 Denmark, the Republic of Ireland and the United Kingdom joined the EC. Greece followed in 1981 and Spain and Portugal became members of the EC in 1986. 2. The governors of the central banks of the then members of the EC, another representative of the European Commission and three independent experts were appointed as members of the Delors Committee. 3. Austria, Finland and Sweden joined the EU in 1995. In 2004, Estonia, Latvia, Lithuania, Poland, the Czech Republic, Slovakia, Hungary, Slovenia, Malta and the Republic of Cyprus joined as part of the eastward enlargement of the EU. Romania and Bulgaria followed in 2007 and Croatia in 2013. It is noteworthy that Switzerland and Norway are not members of the EU. 4. Others were the Treaty of Amsterdam (1997) and the Treaty of Nice (2001). 5. Revenues from customs duties are an exception and flow directly into the central budget. They are limited in quantitative terms.

2

From the Bretton Woods system to European Monetary Union

1. Spain in 1989, the UK in 1990, Portugal in 1992, Austria in 1995, Finland in 1996 and Greece in 1998.

3

The Maastricht Treaty and the Stability and Growth Pact

1. On the historical course in detail, see Kenen (1995). 2. Der Spiegel (1996) reports, among other things, that in France, for example, the state-owned group France Télécom transferred 37.5 billion francs to the public budget in return, the government assumed the group’s pension obligations for the next few decades. The transfer accounted for as much as 0.5 per cent of GDP. Italy is said to have hidden a substantial amount of the public budget by creative accounting (more than €10 billion) in its balance sheet. In Germany it was decided that a new railway line should be pre-financed by private investors and then bought in the year 2000 by the state. 3. When I build a model in which it is assumed that all swans are black and I make the assumption of rational expectations then all agents in the model believe that only black swans exist. Rational expectations are a method to eliminate expectations of economic subjects as an independent factor in models and thus to determine them as endogenous. If expectations are determined exogenously, as in Keynes (1936), then they play a decisive role for economic development and the pure determination of equilibrium by supply conditions is no longer possible. 4. See the statement of the renowned German Macroeconomic Policy Institute (IMK) at a hearing of the Finance Committee of the German Bundestag in January 2005 (Horn & Truger 2005). 5. Since economic theory cannot be used to determine an optimal public debt ratio, it must ultimately be set politically.

4

Structure, political and legal framework of the European Central Bank

1. In order to ensure continuity of work, the terms of the contracts are staggered in the Governing Council and the Executive Board. For this reason, when the ECB was founded, a number of members of the Executive Board received shorter contracts. 2. The Great Financial Crisis (starting in 2007 and deepening in 2008) and the Great Recession in 2009 have been coined to characterize the dramatic developments in the late 2000s (see for example Stiglitz 2010). 3. This was and is the Comptroller of the Currency. The Office of the Comptroller of the Currency, a department of the US Treasury, oversees the execution of laws relating to national banks. 4. In the Protocol on the Statute of ECB it is written: “In accordance with Article 101 of this Treaty, overdrafts or any

other type of credit facility with the ECB or with the national central banks in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments” (ECB 2019f: Article 21). 5. “The Federal Reserve Act specifies that the Federal Reserve may buy and sell Treasury securities only in the ‘open market’. The Federal Reserve meets this statutory requirement by conducting its purchases and sales of securities chiefly through transactions with a group of major financial firms – so-called primary dealers – that have an established trading relationship with the Federal Reserve Bank of New York” (Board of Governors of the Federal Reserve System 2019: para 1). 6. Before that, the classical discount credit existed. 7. Other ordoliberal economists preferred models like the World Trade Organization as they favoured technocratic rule on a world level.

5

Preconditions for a stable monetary union

1. Sometimes the “Pigou effect” is mentioned. If there is net monetary wealth in a currency area then a sharp deflation leads to increasing net real monetary wealth. This then stimulates demand and leads to an end of the deflation. This effect compared with the negative effects of deflation – for example increasing real debt burden and financial crisis – is ridiculous. 2. For the EU the percentages in favour of the euro were 62 per cent in 2018 and 63 per cent in 2004 and against 32 per cent in 2018 and 31 per cent in 2004.

6

The failure of the two-pillar strategy of the ECB and the revival of Wicksell

1. There are many different factors that determine the international role of a currency and the extent to which a financial system is penetrated by foreign currencies (see Herr 1992; Cohen 1998; Fritz et al. 2018). 2. Of course, a firm can also obtain finance in the form of equity and also can use undistributed profits to invest. 3. For own funds the interest rate presents the opportunity costs. 4. The EZB defined M3 as follows: M1 is the sum of currency in circulation and overnight deposits; M2 is the sum of M1, deposits with an agreed maturity of up to two years and deposits redeemable at notice of up to three months; and M3 is the sum of M2, repurchase agreements, money market fund shares and debt securities with a maturity of up to two years (ECB 2019). 5. The dot-com boom from 1994 to 2000 – also known as the tech or internet bubble – was a speculative stock market bubble based on extremely positive expectations regarding the new technologies. The bubble was accompanied by high investments and relatively high growth. 6. Productivity of labour is measured by physical output divided by physical labour input. Productivity of capital cannot be measured as there is no physical unit of capital. It makes no sense to measure capital in tonnes or metres. To measure the physical capital stock in a country in money does not help. On a macroeconomic level to measure a marginal productivity of capital is not possible as the value of the capital stock, which is needed to measure the marginal productivity, is itself dependent on the rate of return for capital (Herr 2019).

7 

Increasing economic fragility in the EMU before the financial crisis

1. Unemployment declined with the upswing in most EMU countries. Overall, it fell from 9.4 per cent in 2004 to 7.4 per cent in 2008. The corresponding figures for France were 8.9 per cent and 7.4 per cent, for Germany 10.6 per cent and 7.6 per cent, for Greece 11 per cent and 8.2 per cent (2007), for Italy 7.8 per cent and 6.7 per cent. The low GDP growth led in Portugal to an increase of the unemployment rate from 7.8 per cent to 8.8 per cent. In the United States, the unemployment rate fell from 5.5 per cent to 4.6 per cent over the same period (OECD 2020). 2. Germany recorded a 31.6 per cent increase in property prices between 1989 and 1995, in particular as a result of German unification. After that, real estate prices stabilized until the Great Recession. 3. Bundesverband der Deutschen Industrie.

4. Bundesverband Deutscher Banken.

8 

Monetary policy during the Great Recession

1. Mark-to-market accounting adds to the problem as assets in a bubble are valued higher and in asset price deflation have to be adjusted to the actual market value. 2. Covered bonds are debt securities issued by financial institutions to refinance a specific pool of credits; in the event the financial institution becomes insolvent, the holder of the bond can dispose the asset behind the bond. Covered bonds are popular in Europe. 3. The calculation of structural budget balances is not undisputed (for a critique see Chapter 8). For example, the calculation of the potential GDP is problematic, since it is itself influenced by fiscal policy.

9

Monetary policy and the escalation of the euro crisis until 2012

1. German Chancellor Angela Merkel, for example, said in 2011: “It’s also about the fact that in countries like Greece, Spain and Portugal you can’t retire sooner than in Germany, but that everyone makes a little equal effort – that’s important … We can’t have one currency and one gets lots of holidays and the other very little. That doesn’t work in the long run” (quoted in “The myth of the lazy Southern European”, Spiegel online 2011: para 5). The highest-circulation German daily Bild wrote on 2 March 2010: “Cheat-Greeks are destroying our euro with their debt drama”; and on 10 May 2010: “We have paid the bill – while others are shamelessly partying at our expense” (Linksnet 2012: para 4). 2. Target stands for trans-European automated real-time gross settlement express transfer system. 3. Economic policy in the EMU during this phase was heavily criticized by a number of authors, including Bibow (2017), Blyth (2013), Detzer & Hein (2015) and Stiglitz (2016).

10 1.

2.

11 1.

2.

3.

The ECB holds the euro together When Draghi’s strategy was adopted on 28 October 2019, President Macron and Chancellor Merkel thanked him. Merkel described him as a “great European”. In this context the Süddeutsche Zeitung (2019: para 15) correctly writes about Draghi’s promise in 2012: “Merkel let it go, she supported Draghi’s monetary policy confidentially in the European interest”. She did it despite widespread criticism of Draghi by German economists and politicians. The dispute over the ECB’s APP programme was also fought out on legal grounds in Germany. German critics of ECB policy brought the case to the German Constitutional Court with the argumentation that the ECB unauthorized finances to public households. In 2017 the German Constitutional Court transferred the case to the European Court of Justice. The latter in 2018 found the ECB’s practice legally correct.

The fiscal policy framework in the EMU: no partner for the ECB In order to determine the hypothetical GDP over the business cycle a Cobb–Douglas production function is usually assumed. This means, in essence, that real GDP is a function of the real capital stock K and labour input H, i.e. GDP = f(K, H). The development of the capital stock and the labour input is estimated on the basis of past data, assuming a certain level of technological progress that increases productivity. The difference between actual and the calculated potential output indicates the output gap. For example, it is unclear how far back economists should go to forecast potential future GDP by extrapolating past developments and how these should be weighted: 5 years, 10 years or 20 years and with linear, progressive or diminishing weighting of these periods? This regulation was the background to the ECo’s dispute with Italy at the end of 2018: although Italy did not breach the 3 per cent-budget rule it did not reduce its national debt in line with the tightened SGP.

12 Financial market supervision, Banking Union and financial market regulation 1. 2.

3. 4.

5.

6. 7.

8. 9.

10.

Iceland, Norway and Liechtenstein as countries outside the EU are also integrated into the ESAs. Together with the EU, they form the European Economic Area. Details of the integration of these countries will not be discussed here. A trade repository (or swap data repository) is an entity that collects and maintains the records of over-the-counter derivatives. These are derivatives which are not traded in organized exchanges. Trade repositories are important in creating a certain level of transparency in derivative markets. In the EU there are about ten such entities. The Scientific Committee comprises 15 experts, while the Technical Committee includes representatives of all EMU central banks, all EMU financial supervisors and representatives of the ESAs. In Belgium, the costs incurred by governments to restructure the financial system after the subprime crisis up to 2011 amounted to 4.1 per cent of GDP, in Ireland 28.7 per cent, in Greece 5 per cent, in the Netherlands 6 per cent and in Spain 2 per cent (IMF 2011: 8). After 2011, banks in southern European countries continued to come under pressure due to the worsening of the real estate crisis and the poor economic development, so that massive additional government support became necessary. The risk-weighted capital ratio (RWC) of a bank for three types of assets is calculated as follows: RWC = C/(r1·A1 + r2·A2 + r3·A3) where C is the capital of the bank, r1, r2 and r3 are risk weights and A1, A2, A3 are credits. If we assume that a bank has domestic loans to public authorities of €200 million, mortgage-backed securities of €100 million and loans to companies of €700 million and has a capital of €64 million, then RWC = 64 million/(0·100 million + 0.5·200 million + 1·700 million) = 64 million/800 million = 8 per cent. Rating agencies used the same method to evaluate risks of credits or complex financial products. A distinction is made between Tier I capital and Tier II capital. Tier I capital consists of common capital and additional Tier I capital. With 8 per cent capital, banks must hold at least 4.5 per cent common capital, 1.5 per cent additional Tier I capital and 2 per cent Tier II capital. The quality of loss coverage is highest for common capital and lowest for Tier II capital. BNP Paribas (FR), Deutsche Bank (DE), BPCE (FR), Crédit Agricole (FR), ING (NL), Santander (ES), Société Générale (FR) and Unicredit (IT). Let’s hope history doesn’t repeat itself. On 5 November 2008 during a briefing by academics at the London School of Economics on the turmoil on the international financial markets the Queen asked: “Why did nobody notice it?” She found the turbulences, which also diminished her wealth substantially, “awful”. Professor Luis Garicano, director of research at the LSE’s management department said: “She was asking me if these things were so large how come everyone missed it”. He told the Queen: “At every stage, someone was relying on somebody else and everyone thought they were doing the right thing” (Telegraph 2008: para 1ff.). One is surprised why the mainstream does not rely, here, on the Modigliani–Miller theorem which shows that under certain condition the financing structure of economic units plays no role and equity holding can be very high (Modigliani & Miller 1958).

13 The Covid-19 crisis and its effects on the EMU 1.

2.

3. 4. 5.

Reduced hours compensation (furlough) amounts to 60 per cent of the lost net wage and for those with parental obligations 67 per cent. Payments are gradually increased over time with payments rising to up to 80 per cent, or to 87 per cent for those with children. Social security contributions are also paid by the Federal Labour Office (BMF 2020). As a result of this measure, employees remain in employment albeit with a lower salary. Temporary workers are also covered by this programme. This instrument had proved its worth in the Great Recession to prevent high levels of open unemployment. At the end of April 2020, interest rates on the secondary market for government securities close to 10 years maturity were -0.45 per cent in Germany, -0.22 per cent in the Netherlands, 0.06 per cent in France, 0.82 per cent in Spain, 0.97 per cent in Portugal, 1.8 per cent in Italy and 2.05 per cent in Greece (ECB 2020e). The expected inflation rate in Greece is -0.6 per cent, in Italy and Ireland -0.3 per cent and in Portugal -0.2 per cent (ECo 2020). Non-performing loans and advances as share of loans and advances. There is an international dimension to the problem. Severe world recessions lead almost automatically to massive capital flight from countries with weak currencies to hegemonic capitalist states, which issue the world’s leading currencies. Big and small wealth owners in the former follow their asset protecting strategy and try to hold wealth in

world-dominating currencies such as the US dollar or the euro. At the same time, international capital flows to countries with already weak currencies dry up. In such a constellation it becomes extremely difficult, if not impossible, for countries with weak currencies to service or restructure their foreign debt, which is almost always denominated in foreign currency. To make matters worse, exchange rates of these countries collapse. This triggers a disastrous real debt effect as, for domestic agents in these countries, it becomes more difficult to service their foreign debt. This exchangerate driven real-debt effect is much faster and more violent than deflation as exchange rates can move much faster than wages and price levels. During the Covid-19 crisis most emerging and developing countries suffered from the described effects. The economic historian Charles Kindleberger (1986) stressed that the Great Depression only became so deep because: (a) there was no international lender of last resort and so no institutions and no cooperation to help countries with external problems; (b) there was no anti-cyclical, politically driven capital flow from countries with no external problems to countries with severe external problems; and (c) countries with no external problems followed protectionist policies to stimulate their employment and reduced their imports. To take over responsibility for countries in the Global South and also to prevent the collapse of the world economy, the EMU has to help countries in the Global South.

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INDEX

accountability of central banks 35–6 asset-backed securities purchase programme (ABSPP) 115–16 asset bubble 46, 67–9 asset purchase programme (APP) 114–16, 180 austerity policy 42, 43, 77, 100, 104, 163, 171 automatic stabilizers 41, 174 bad bank 171–2 balance sheet ECB 94, 153 banking union 139–42, 147, 162 Basel I 142–3, 148 Basel II 135–6, 143–5 Basel III 139, 142–3, 146–7 Basel Committee on Banking Supervision (BCBS) 143, 146 boom-bust cycle 44 Bretton Woods System 2, 9–12, 15, 81–2 capital buffers 144–6, 148 capital market 101–02, 142 capital requirements 144–8 corporate sector purchasing programme (CSPP) 116 covered bond purchase programme (CBPP) 93 currency swaps 93, 117, 154 current account imbalances 9, 13, 46, 76–7, 80, 83 D-Mark 10–17, 80–2 debt brake 97, 101, 119, 123–7, 155, 157 debt crises 43–4, 112, 124, 151, 174 deflation 40, 59, 109, 159–60, 173 Delors Report 2–3 deposit insurance 43, 46, 89, 140–2, 172

Deutsche Bundesbank 2–4, 12–15, 30, 56, 80–82, 105, 123, 139 devaluation inflation spiral 11, 102, 175 internal 100, 104, 109, 120 discount window 34, 57, 92, 117 discretionary monetary policy 54, 59, 64 Draghi, Mario 62, 111, 119, 153, 176 Economic and Financial Affairs Council (ECOFIN) 5, 32–5, 79, 127–33 euro bonds 142, 158, 170–1 Eurogroup 7, 100, 132, 152, 166 European Banking Authority (EBA) 137–8, 146 European Banking Union 139 European Central Bank (ECB) Executive Board 25–7, 178 Governing Council 6–7, 26–7, 31, 34–6, 55, 105, 152 European Currency Snake 11 European Currency Unit 12 European deposit insurance scheme 140–2 European Financial Stability Facility (EFSF) 101–04 European Financial Stabilization Mechanism (EFSM) 101 European Insurance and Occupational Pensions Authority (EIOPA) 137 European Monetary Institute 16 European Monetary System (EMS) 2–3, 12–15 European Parliament 5–7, 35, 47, 159, 163, 166, 170 European Securities and Market Authority (ESMA) 137–8 European Semester 127, 132 European Single Act 2 European Stability Mechanism (ESM) 103–04, 157, 170–2 European Supervisory Authorities (ESAs) 137–8 European System of Central Banks (ESCB) 16, 25, 31, 36, 93 General Council of the ESCB 25 European System of Financial Supervision (ESFS) 135–9 European Systemic Risk Board (ESRB) 138–39, 145–6 exchange rate policy 11, 32 federal funds rate 84, 118 Federal Open Market Committee (FOMC) 27, 29, 31, 35

financial market regulation 8, 135, 142–4, 149, 171 Financial Stability Board (FSB) 144, 146 Financial Stability Committee 139, 145 fine-tuning operations 33 fiscal compact 125, 127, 130–2 forward guidance 62 German unification 3, 13–4, 16 Glass–Steagall Act 148 golden rule of fiscal policy 22–3, 124, 126, 171 Great Financial Crisis (2007/08) 34–5, 37, 42, 54, 87, 99, 165 Great Recession 54, 87–8, 91, 99 Greek crisis 100–05 green bonds 116 hyperinflation 41, 102 independence of central banks 17, 28–30 financial independence 31 instrument independence 32–3 no financing of public budgets 17, 30–1 personal independence 31 target independence 31–2 inflation 40–1, 44–5, 51–2, 56, 64, 71, 102 target 32, 54, 60–1, 64, 169–70 targeting 54, 61 interest rates long-term 18–19, 65–6 natural interest rate 61–4 International Monetary Fund (IMF) 43, 100 Ireland 108–09 Keynesian paradigm 39, 51–5, 63–4 labour market 18, 40–1, 44–5, 159–60, 173 Lagarde, Christine 153 lender of last resort 43, 89, 93, 103–04, 107, 161, 168 for governments 19, 28, 30, 41, 44, 100–02, 111–12, 175

leverage ratio 146–7 liquidity ratio 146–7 Lisbon Treaty 5 Maastricht criteria 18–19 Maastricht Treaty 4, 15–18 macro-prudential supervision 136–7, 147 macroeconomic dialogue 74–5, 85, 173 macroeconomic imbalance procedure 128–30, 173 macroeconomic production function 125 macroeconomic regime 65, 80–3 debt driven 82–3 mercantilist 80–1 stagnation 83 sustainable domestic demand driven 83 main refinancing operation, see monetary policy microeconomic supervision 136 minimum wage 45, 74, 173 monetarism 55 monetary aggregate 53–6, 60 monetary policy conventional 33, 35, 114, 152 collateral 33–4, 92, 152–3 deposit facility 34, 57, 112, 114 longer-term financing operations 33 main refinancing operation 33–4, 92, 107, 112, 114, 152 marginal lending (standing) facility 33–4, 57, 92, 112 minimum reserves 27, 34–5 quantitative easing 111–12, 118–20 unconventional 35, 114–17 monetary targeting 56, 59–62, 64 money neutrality 28, 39 theoretical foundation 51–3 money market 33–4, 57, 60, 88–9, 93, 105–06, 112, 117 mortgage-backed securities 87, 118, 143 NAIRU 64

neoclassical paradigm 21, 28, 60–1, 135 no-bail-out clause 17, 20, 44, 99, 102 non-performing loans (NPL) 161–2 open market operations 19, 27, 33–4 optimal currency area 47–9 outright monetary transactions (OMT) 111–12, 153 pandemic emergency longer-term refinancing operations (PELTROs) 152–3 pandemic emergency purchase programme (PEPP) 153, 157 public sector purchase programme (PSPP) 115, 154–5 quantity theory of money 55, 64 rational expectations 21, 177 real estate sector 42, 67–8, 75, 88, 120, 149, 172 risk models 136, 143–8 securities markets programme (SMP) 104–05, 112 shadow banking/financial system 138, 144, 147–9, 172 share prices 68, 113 Single Resolution Fund 140–1, 162 single supervisory mechanism 140–1, 162, 171 Sixpack 127–30 Stability and Growth Pact (SGP) 19–23, 77–80, 123–4, 127–9, 131 stress test 137 structural budget balance/deficit 95–6, 117, 124–7, 132 subprime crises 87, 140–1, 144 Target2-balances 104–07, 115 target longer-term refinancing operations (TLTROs) 114, 152–3 tenders 57–8 time inconsistency 29 trade unions 45, 73–4, 80–1, 159–60 Treaty of Rome 1–2 Trichet, Jean-Claude 92, 107 Troika 100, 103, 107, 109–10, 120, 165, 173 two-pillar strategy 51, 54–6, 61, 65, 85 Twopack 127, 131–2

Volcker rule 149 wage anchor 40, 160 Werner Plan 10–11