Address by Director of Economics and Chief Economist, Lars Frisell to Institute of International and European Affairs 

27 February 2013

Transitioning from a currency union to a banking union – fiscal and monetary considerations

Last week the ECB released the details of its sovereign debt portfolio acquired under the Securities Market Programme (SMP).  Amounting to some €218 billion of holdings, the figures give an idea of how important the ECB’s intervention has been for peripheral countries.  The ECB holds about 40% of outstanding Greek bonds, 25% of Portugal’s and 12% of the Irish bonds.  Despite the size of the intervention, the SMP proved to be an insufficient step to contain sovereign yields in the periphery, yields that in some instances indeed seemed to embody a redenomination risk of the currency.  In the summer of 2012 additional steps were taken to restore confidence in the common currency.  Since the June 2012 Heads of State statement, and the ECB’s announcement of Outright Monetary Transactions, interest rate spreads for peripheral countries have fallen dramatically, not least so in the case of Ireland.

But these measures are hardly sufficient to resolve the longer-term challenges in the euro area.  Europe has set up, if you will, a “good-weather” currency union, which is not fully equipped for a large-scale debt crisis.  That the euro was designed without some protective features that might prove necessary was argued by many in advance.  However, it took a good decade for gaps to be exposed in practice.  Let me quickly mention some of the issues discussed before the euro began.  The literature on optimum currency areas, following Robert Mundell’s pioneering work, lists four criteria for a successful currency union.[1]

A first condition is sufficient labour and capital mobility across the currency area, of which Mundell mainly stressed the former.  The European Union has gone a long way to accomplish this, embodied through its “four freedoms”.  However, the fact that tax codes and pension systems operate on a national basis poses a barrier.  And, more importantly, language barriers still hamper labour mobility to a great extent.  The complete dominance of Anglo-Saxon countries as preferred hosts for Irish emigrants is a case in point.

A second condition is sufficient price and wage flexibility across the region.  In practice wage flexibility is limited, and downward adjustments are very rare.  Some flexibility in the overall wage bill can be achieved by other means, such as reducing worked hours or overtime, but the feasibility of these options varies greatly between countries, and overall wage flexibility is still much lower in Europe than in the US.  Ireland and several of the other peripheral countries in Europe are now in a painful process of trying to adjust labour costs after a long period of exaggerated wage increases – not the least in the public sector.

Both the conditions above are necessary to achieve efficient reallocation of factors of production.

Thirdly, and connected to the first two conditions, the business cycles of the participating countries should be relatively well synchronised.  If the occurrence of country-specific shocks is too frequent, the single central bank cannot use monetary policy efficiently to either promote growth in downturns nor to contain inflation in booms.  If the participating countries are connected by significant trade links the first criteria is likely to hold, but the risk for idiosyncratic shocks – as we have witnessed – is always present.

Finally, and this becomes more pertinent the less the three previous conditions are fulfilled, there is a need for a risk-sharing system so that funds can be redistributed to sectors, regions and countries that have suffered severe shocks.  Although the EU has structural and regional funds to support growth in less developed areas in the union, these are, of course, neither intended nor close to sufficient to provide the backstop in a systemic banking crisis.  Indeed, transfers of this kind are explicitly prohibited in the European Union, as formalised by the so-called no-bailout clause in the Stability and Growth Pact.  This enshrined absence of risk-sharing among the participating members is not a minor imperfection in the union’s setup, it is a fundamental disadvantage.  But a super-national system of risk-sharing should of course be fairly priced, and as little subject to gaming as possible.

The Maastricht criteria, including the 60% debt-to-GDP limit and the three per cent deficit budget limit, were introduced to prevent fiscal shocks from overwhelming the capacity of any sovereign, hence foiling the need for euro-wide transfers.  As you know these rules were ignored by many countries over the past decade, including France and Germany.  But one should bear in mind that, as the case of Ireland illustrates, where debt-to-GDP went from below 30% to over 100% in a matter of a couple of years, such rules can hardly eliminate the need for a risk-sharing mechanism.

I think that a factor not sufficiently stressed in the classic Mundell analysis is the role of the banking system, which may propagate any real or perceived weakness in the sovereign.  The bank-sovereign link is present in any country with systemic banks, but it is worth highlighting why it becomes so acute in a currency union.

When a sovereign has its own (floating) currency, persistent high inflation or fiscal deficits will translate into investors’ demanding a higher premium to hold the sovereign’s bonds, and its currency will continuously depreciate.  Currency depreciation implies that current account deficits will start correcting automatically as higher prices on imported goods, and higher profits in the export sector, will lead factors of production to the tradables sector.  And costlier external funding will send an increasingly strong signal to the government that it is on an unsustainable policy path.  Although sudden defaults occur also in countries with floating exchange rates, as when the Icelandic banks brought their country to a collapse, confidence is most often eroded gradually over time.

In a currency union however, budget and current account deficits do not result in a depreciating currency and an automatic reallocation of labour and capital. But a perceived redenomination or credit risk should still translate into higher risk premia on the sovereign’s bonds.  Why did we not observe this during the first decade of the euro?  As you know, sovereign yields converged until 2007 to an unprecedented degree, where, for example, the yield of the Greek 10-year bond at some point was less than 20 basis points over its German counterpart. I think there were two reasons.  The first is the general and significant under-pricing of risk in the half decade or so marked by the great moderation.  But the second reason is simply that the commitment to the euro is credible.  Before the Lisbon Treaty there was not even an agreed process by which an exit from the EU could take place.  And even more powerful, the cost would probably be prohibitive. There are scholars who have tried to estimate the costs of an euro exit for different countries but suffice to say that even compared to abandoning a currency peg, as several countries did at significant cost during the ERM crisis in 1992-93, attempting to re-launch a non-existent currency must entail large welfare costs.  The costs will be primarily indirect due to the enormous uncertainty - legal, financial, and political – that is likely to prevail for an extended period of time.  However, in theory there is of course nothing to prevent the write-down of sovereign debt while remaining in a currency area. This happens occasionally to states in the US, and it happened eventually also in the case of Greece.  But the potential costs to the currency union are very high, as a majority of creditors are likely to be European financial firms and other European sovereigns.  It is therefore quite understandable, for both economic and political reasons, that investors regarded this risk as negligible, and that they priced peripheral bonds accordingly. 

When the costs of redenomination or default are so high, we find ourselves in a polar world with two distinct equilibria.  As long as the gain from defaulting is lower than the cost, and it is likely to stay that way, the risk is negligible.  But if the hurdle suddenly is passed, and sovereign debt suddenly looks unsustainable, what looked like a political impossibility may quickly become a likely scenario.  I think this is what largely occurred during the repeated revisions of Greece’s budget deficit in 2009.  The fiscal position that eventually emerged was so poor that the cost of restoring fiscal balance seemed economically and or politically impossible.  Default of that country was suddenly a distinct reality.

The emergence of a sovereign’s default risk can be destructive for its banks for at least two reasons.[2]  First, due to both business logic and regulation, banks hold large amounts of their own sovereign’s debt on their balance sheets. Sovereign bonds typically form the bulk of a bank’s most liquid reserves, used as collateral to raise cash via repo transactions.  According to the European capital directives – the current as well as the proposed future one – sovereign bonds from EEA countries denominated in their own currency have a risk weight of zero.[3]  In other words, they are by statute deemed risk free.

Second, creditors of many banks in Europe and elsewhere have enjoyed an implicit government guarantee.  Now and then this implicit guarantee becomes explicit, as indeed in the case of Ireland.  But guarantees of different forms have been continuously granted to banks in Europe, where recent examples include Dexia in Belgium, Hypo Real Estate in Germany, and Northern Rock in the UK. This means that investors can rationally expect that banks will continue to be bailed out.  The value of the government guarantees for banks – by reducing their funding costs - can be very large, especially during market turbulence, corresponding to a sizeable share of their funding costs or hundreds of millions a year for a large bank.[4]  In other words, bank profits have been hugely dependent on the credit worthiness of their sovereigns - even if the bank in question never held a single domestic bond on its balance sheet.

Losing this implicit guarantee is a dramatic event for banks, as we have seen over the past years. Funding can drain virtually overnight and the funding still on offer will be much dearer.  Funding conditions today differ wildly across the euro area.  The rate charged by the ECB on its main refinancing operations has decreased by 75 basis points over the last year but the composite cost of borrowing has decreased by a similar or greater amount in only 20 per cent of cases.  In another 20 per cent of cases, it has even increased by more than 25 basis points. This of course translates into the real economy.  The dispersion of lending rates has risen both across jurisdictions and across categories of enterprises.  For example, the cost of short-term borrowing for corporates in France is still around the same level as that recorded at the beginning of 2011; by contrast, in Italy, over the same period of time, the cost of borrowing for corporates has widened by almost 100 basis points.  In addition, in countries facing economic and financial distress, bank financing conditions are tightening further for small and medium-sized enterprises.

In either case – whether the banks contaminated the sovereign, as in the case of Iceland and Ireland, or the other way around as in the case of Greece – many countries may face elevated funding and lending rates for a long time, with huge costs for society in terms of lost growth and employment.  Sovereigns that are struggling to consolidate their fiscal position may not be able to inject sufficient capital into their banks to restore confidence – precisely because this would add further to the sovereign’s indebtedness and further erode the fiscal backstop.

How will we restore the transmission mechanism in the euro area?  Fiscal consolidation and structural reforms in individual countries must of course continue.  Inflexible labour markets, where some professions sometimes are virtually protected from entry, was one reason why wage inflation could accelerate to such extent in peripheral countries.  But these reforms will take many years, possibly with political and legal pushbacks along the way.

At the same time, I do not think we should put too much hope in the potency of further relaxation of monetary policy.  Peripheral countries may find themselves in a liquidity trap – that is, households and investors hold on to their cash due to the prevailing uncertainty, so lower interest rates will not translate into the real economy to any great extent.

What remains, then, to break the bank-sovereign link in the short term is a risk-sharing capacity.  A common Eurozone backstop that can supply banks with both capital and liquidity without feeding the sovereigns’ vicious debt circle. Importantly, the equity and debt supplied in this manner does not need to be subsidised, but they have to be provided at terms compatible with a long-term view of the Sovereigns.  Once the thorny issue of legacy assets can be settled, a European fund could act as a patient, deep-pocket investor that provides assurance to creditors that, in the event of any further negative surprise, future capital needs will be met.  And, naturally, if the backstop will be a Euro area liability, it is natural that bank supervision comes firmer under centralised control.

In the longer term, but hopefully not too long, we must come to a situation where banks can be resolved smoothly without threatening financial stability or at significant cost to taxpayers.  Shareholders and creditors of large banks, like those of any other company, should suffer the losses in case of default. When we have reached this state, the risk that a Eurozone backstop will actually be called upon will be greatly diminished.


[1] Mundell, R. A. (1961) “A Theory of Optimum Currency Areas”, American Economic Review 51: 657-665.

[2] The risk that banks’ balance sheets would be contaminated by sovereign risk was highlighted at an early stage by Barry Eichengreen and Charles Wyplosz (1998).

[3]Directive 2006/48/EC Annex VI, Part I, 1.2.4 .

[4]See, for example McArthur (2009) and Ueda and di Mauro (2012).