Beblavy et al (eds ) the euro area and the financial crisis (2011)

The Euro Area and the Financial Crisis

The financial crisis of 2007–10 has presented a number of key policy
challenges for those concerned with the long-term stability of the euro
area. It has shown that price stability as provided by the European
Central Bank is not enough to guarantee financial stability, and exposed
fault lines in governance and deficiencies in the architecture of the
financial supervisory and regulatory framework. This book addresses
these and other issues, including why the crisis affected some countries
more than others, whether the euro is still attractive for new EU states
and what policy changes and structural reforms, both macro and micro,
should be undertaken to ensure its future viability. Written by a team of
leading academic and central bank economists, the book also includes
chapters on the cross-country incidence of the crisis, the Irish crisis
and ECB monetary policy during the crisis, and studies on Spain, the
Baltics, Slovakia and Slovenia.
m i r o s l av b e b l av y´ has an unusual blend of academic and political
experience. He is a Senior Research Fellow at the Brussels think tank,
Centre for European Policy Studies and, at the same time, Member of
the Slovak Parliament. He is also Associate Professor of Public Policy at
the Comenius University in Bratislava, Slovakia. In the past, he served
as a junior minister in his country’s government, created an influential
think tank and worked for a range of multilateral development institutions as a consultant in Europe, Africa and the Caucasus.
d av i d c o b h a m is Professor of Economics at Heriot–Watt University.
He is a specialist in monetary policy who has worked on the UK, on
French and Italian monetary policy, on European monetary integration
and on monetary policy and exchange rate regimes in the Middle East
and North Africa. He is the editor or co-editor of a number of books
on European monetary integration and monetary policy, including The
Travails of the Eurozone (2007) and Twenty Years of Inflation Targeting:

Lessons Learned and Future Prospects (2010).
l ’ u d ov ´i t o´ d o r is an advisor to the Prime Minister and Minister of
Finance in Slovakia. In the past, he served as a member of the Bank
Board at the National Bank of Slovakia and Executive Director responsible for research. He also worked as a Chief Economist at the Ministry
of Finance of the Slovak Republic. He played an important role in institutional and structural reforms in Slovakia including the euro adoption
in 2009.



The Euro Area and the
Financial Crisis
Edited by

Miroslav Beblav´y, David Cobham
´
and L’udov´ıt Odor


c a m b r i d g e u n i ve r s i t y p r e s s
Cambridge, New York, Melbourne, Madrid, Cape Town,
Singapore, S˜ao Paulo, Delhi, Tokyo, Mexico City
Cambridge University Press
The Edinburgh Building, Cambridge CB2 8RU, UK
Published in the United States of America by
Cambridge University Press, New York
www.cambridge.org
Information on this title: www.cambridge.org/9781107014749
C

Cambridge University Press 2011

This publication is in copyright. Subject to statutory exception
and to the provisions of relevant collective licensing agreements,
no reproduction of any part may take place without the written
permission of Cambridge University Press.
First published 2011
Printed in the United Kingdom at the University Press, Cambridge
A catalogue record for this publication is available from the British Library
Library of Congress Cataloguing in Publication data
The Euro area and the financial crisis / edited by Miroslav Beblav´y, David
´
Cobham, and L’udov´ıt Odor.
p. cm.
“This volume brings together the papers and panel contributions presented at
the conference on ‘The Euro Area and the Financial Crisis’, held in Bratislava
from 6 to 8 September 2010” – Introd.
Includes bibliographical references and index.
ISBN 978-1-107-01474-9
1. Monetary policy – European Union countries. 2. Euro.
3. Global Financial Crisis, 2008–2009. I. Beblav´y, Miroslav.
´
II. Cobham, David P. III. Odor,
Ludov´ıt. IV. Title.
HG925.E8677 2011
330.94 05611 – dc23
2011027489
ISBN 978-1-107-01474-9 Hardback

Cambridge University Press has no responsibility for the persistence or
accuracy of URLs for external or third-party internet websites referred to

in this publication, and does not guarantee that any content on such
websites is, or will remain, accurate or appropriate.


Contents

List of figures
List of tables
List of boxes
List of contributors
List of abbreviations and acronyms

page viii
xi
xiv
xv
xvii

1 Introduction
m i r o s l av b e b l av y´ , d av i d c o b h a m a n d
l ’ u d ov ´i t o´ d o r
2 Towards a new architecture for financial
stability in Europe
athanasios orphanides

1

8

Part I The experience of the crisis

3 Weathering the financial storm: the importance of
fundamentals and flexibility
t h o r va r d u r t j o¨ r v i o´ l a f s s o n a n d t h o´ r a r i n n
g . p e´ t u r s s o n

23

4 The Irish crisis
p h i l i p r. l a n e

59

5 The crisis in Spain: origins and developments
a n g e l g av i l a´ n , p a b l o h e r n a´ n d e z d e c o s ,
juan f . jimeno and juan a. rojas

81

6 The financial crisis and the Baltic countries
a u r e l i j u s d a b u sˇ i n s k a s a n d m a r t t i r a n d ve e r

97

v


vi

Contents

Part II Accession to the euro area
7 The road to euro adoption: a comparison of Slovakia
and Slovenia
b i sw a j i t b a n e r j e e , d a m j a n k o z a m e r n i k a n d
l ’ u d ov ´i t o´ d o r
8 Is the euro really a ‘teuro’? The effects of introducing
the euro on prices of everyday non-tradables in
Slovakia
m i r o s l av b e b l av y´
9 The euro’s contribution to economic stability in Central,
Eastern and Southeastern Europe: is euro adoption still
attractive?
e w a l d n owo t ny
10 Is the euro still attractive for CEE countries?
z d e n eˇ k t u˚ m a a n d d av i d v a´ v r a

131

157

184
190

Part III The future of the euro area
11 Why the current account may matter in a monetary
union: lessons from the financial crisis in the
euro area
f r a n c e s c o g i ava z z i a n d l u i g i s p ave n t a

199

12 National fiscal rules within the EU framework
daniele franco and stefania zotteri

222

13 The road to better resolution: from bail-out to bail-in
thomas f . huer tas

243

14 Financial stability and monetary policy: lessons from the
euro area
l a u r e n t c l e r c a n d b e n oˆı t m o j o n
15 Is there a case for price-level targeting?
b o r i s c o u r n e` d e a n d d i e g o m o c c e r o
16 Heterogeneity in the euro area and why it matters for the
future of the currency union
we n d y c a r l i n

268
292

320


Contents

vii

17 The euro area: how to regain confidence?
v ´i t o r g a s p a r

329

18 How to regain confidence in the euro area?
stefan gerlach

335

19 How to save the euro? Lessons from the US
j a c q u e s m e´ l i t z

340

Index

344


Figures

4.1 Ratio of private credit to GDP, 1984–2008
page 62
4.2 Net foreign liabilities of the Irish banking
system, 2003–10
63
4.3 Current account balance, 1998–2010
64
4.4 Spread between ten-year bonds: Ireland over

Germany, 2007–10
70
5.1 Ex post real interest rates, 1995–2008
83
5.2 Age distribution of immigration inflows
84
5.3 Public finances, 1995–2008
84
5.4 Public debt, 1995–2008
85
5.5 External imbalance, 1995–2008
85
5.6 Current account balance, 1995–2008
86
5.7 Demographic changes: data vs. model, 1998–2008
88
5.8 Demographic and interest rate changes: data vs.
model, 1998–2008
90
6.1 Comparison with previous recessions
100
6.2 Comparison of the Baltic States, 2004–9 or 2004–10
106
6.3 Output gap and REER indexes: Baltic States, 2004–9
118
6.4 Merchandise export and REER indexes: Baltic
States, 2004–9
118
6.5 Output gaps: Baltic States, July 2010
estimates, 2000–11

120
6.6 Output gap for 2007: forecasts and estimates, 2005–10
121
7.1 Twelve-month HICP inflation and the Maastricht
inflation criterion, 2000–10
135
7.2 Unit labour costs, 2000–9
138
7.3 Output gap estimates for Slovakia by alternative
methods, 2000–8
139
7.4 Real exchange rates: Slovenia, 2000–10
144
7.5 Exchange rate and forex interventions: Slovakia, 2004–8
146
8.1 HICP inflation: euro area, the Czech Republic and
Slovakia, 2001–10
164
viii


List of figures

8.2 HICP inflation for passenger transport: Eurozone, Czech
Republic and Slovakia, 2001–10
8.3 HICP inflation in restaurants, caf´es and similar
establishments: Eurozone, Czech Republic and
Slovakia, 2000–10
8.4 HICP inflation in hairdressing salons and personal
grooming establishments: Eurozone, Czech Republic and

Slovakia, 2000–10
8.5 Perceived inflation: Eurozone, Czech Republic and
Slovakia, 2001–10
8.6 Correlation of twelve-month moving sample of the Slovak
HICP with Eurozone and Czech HICP, 2001–10
9.1 (a) Output growth, 2006–10 and (b) output differential,
2003–15: CEE and euro area
10.1 GDP per capita: OECD country groups
10.2 Real exchange rates: euro area, normalised, 1999–2009
10.3 Trade balance: euro area
10.4 Inflation rates before and after EMU entry
10.5 Exchange rate and GDP growth during the crisis
10.6 Spreads on government bonds
11.1 The PPF
11.2 Value added in construction, 1999–2009
14.1 Indebtedness of non-financial sectors: US and in the euro
area, 1999–2010
14.2 Short-term interest rates and Taylor benchmarks: (a) euro
area, (b) US, 1999–2009
14.3 HICP inflation: euro area, 1999–2010
14.4 Effects of shocks to credit standards and stance of
monetary policy: euro area countries
14.5 Contribution of credit standards shocks and monetary
policy shocks to variance of variables of interest: euro area
countries
14.6 Counterfactuals without monetary policy
shocks, 1985–2009
14.7 Average daily amount of excess reserves
14.8 ECB key rates, 2006–10
14.9 Spread between three-month interbank and overnight

indexed swap (OIS) rates: euro area and US, 2007–9
14.10 Provision and liquidity absorption by
Eurosystem, 2007–10
14.11 Covered bond spreads against five-year
swap rate, 2008–10

ix

165

166

166
170
171
187
191
191
192
192
193
194
210
213
272
274
275
277

278

280
282
283
284
286
287


x

List of figures

15.1 Prices over long periods: price-level targeting vs. IT in
model simulations
15.2 Price index and price-level target path: selected
countries, 1998–2008
15.3 Response of nominal interest rate to negative demand
shock
15.4 The evolution of the CPI in Sweden, before and after
price-level targeting, 1928–38
15.5 Exchange rate and policy discount rate: Sweden, 1928–38
16.1 Real effective exchange rates, 1999–2009

302
303
306
314
314
326

Tables

3.1 Country sample
page 26
3.2 Regression results for the depth of the output contraction
34
3.3 Regression results for the depth of the consumption
contraction
35
3.4 Regression results for the duration of the output
contraction
37
3.5 Regression results for the duration of the consumption
contraction
38
3.6 Probit estimates of the likelihood of a banking crisis
40
3.7 Probit estimates of the likelihood of a currency crisis
41
3.8 Probit estimates of the likelihood of a banking, currency,
or twin crisis
42
3.A1 Data definitions and sources
52
5.1 Role of demographic changes, 1998–2008
88
5.2 Role of interest rates and demographic changes,
1998–2008
89

5.3 Role of fiscal policy
92
5.4 Role of labour and product market distortions
93
6.1 Correlation between output gap and financial variables:
EU countries, 2004–9
109
6.2 Structure of foreign capital inflows: the Baltic countries,
2004–9
110
6.3 Changes in credit portfolios: selected Nordic banks on
group level and Estonia, 2008Q3–2010Q4
112
6.4 Cyclically adjusted fiscal balance of general government,
2004–10
114
6.5 Impact of EU funds on the cyclically adjusted fiscal
balance of general government: Estonia, 2005–10
115
6.6 Decline in imports among the ten main trading partners
of selected EU new member countries
117
6.A1 Number of recessions covered by different variables and
country groups
126
xi


xii

List of tables

7.1 Selected indicators at landmark dates, 1998–2007
7.2 Contribution of administered price and indirect taxes to
year-on-year inflation, 1999–2008
7.3 Policy dilemma in new member states
7.4 Fiscal indicators, 2000–9
8.1 Answers by Eurozone respondents to the question: ‘For
each of the following, do you personally have the feeling
that, in the conversion to the euro, prices have been . . . ’
8.2 Inflation in selected areas: July after euro adoption vs. the
July prior to euro adoption
8.3 Nominal appreciation/depreciation in the run-up to the
single currency
8.4 Perceived and actual HICP inflation in the six months
prior to and twelve months after euro adoption
8.5 Actual and perceived inflation in period of euro adoption:
Cyprus, the Eurozone, Slovakia and Slovenia
8.6 Summary statistics for datasets measuring changes in the
prices of selected services: Bratislava and Brno, July 2008
and July 2009
8.7 Distribution of price changes for schnitzel and boiled
potatoes: Bratislava and Brno
8.8 Distribution of price changes for a woman’s haircut:
Bratislava and Brno
8.9 Frequency distribution of all price changes in the micro
dataset, July 2008–July 2009
8.10 Comparison of enterprise-level inflation data: Bratislava
and Brno, with national inflation data, July 2008–July
2009

8.A1 Inflation in selected areas, comparing prices eighteen
months and six months prior to euro adoption
8.A2 Inflation in selected areas, comparing prices thirty months
and eighteen months prior to euro adoption
8.A3 Inflation in selected areas, comparing prices forty-two
months and thirty months prior to euro adoption
11.1 General government balance and debt, 2008–9
11.2 Cumulated current accounts, 1999–2008
11.3 Per capita income and labour productivity, 1998, 2000
and 2008
11.4 Potential growth and its components, 1989–2008
11.5 Determinants of growth, 1995–2005
11.6 Households, ratios to gross disposable income, 2000–8
11.7 Domestic credit, ratios to GDP, 2000, 2004 and 2008

132
136
142
149

158
167
168
172
173

174
175
176
176

177
180
181
182
200
201
204
206
206
214
214


List of tables

11.8 Portfolio investment of the four cohesion countries’ share
of total investment, 2001 and 2008
12.1 Most common features of national fiscal frameworks in
EU countries
13.1 Overview of resolution methods
13.2 Bail-in via write down/solvent wind down
13.3 Bail-in via conversion of back-up capital to common
equity
13.4 Bail-in via conversion: timing and decision-maker for
conversion ratios
15.1 The Swedish experience with price-level targeting
Box table 15.1 Compared simulated effects of IT and price-level
targeting
Box table 15.2 Simulation results with backward-looking

behaviour
Box table 15.3 IT vs. price-level targeting at very low equilibrium
inflation rates

xiii

215
227
252
258
260
261
313
298
298
300


Boxes

15.1 Price-level targeting vs. higher inflation targets as
protection against hitting the zero lower bound
15.2 Redistributive effects under inflation and price-level
targeting

xiv

page 296
305

Contributors

b i sw a j i t b a n e r j e e , Haverford College
m i r o s l av b e b l av y´ , Comenius University
we n d y c a r l i n , UCL and CEPR
l a u r e n t c l e r c , Banque de France
d av i d c o b h a m , Heriot–Watt University
b o r i s c o u r n e` d e , OECD
a u r e l i j u s d a b u sˇ i n s k a s , Bank of Estonia
d a n i e l e f r a n c o , Banca d’Italia
v ´i t o r g a s p a r , Banco de Portugal
˜
a n g e l g av i l a´ n , Banco de Espana
s t e f a n g e r l a c h , Goethe University and CEPR
f r a n c e s c o g i ava z z i , Bocconi University, CEPR and NBER
˜
p a b l o h e r n a´ n d e z d e c o s , Banco de Espana
t h o m a s f . h u e r t a s , EBA and FSA
˜
j u a n f . j i m e n o , Banco de Espana
d a m j a n k o z a m e r n i k , Bank of Slovenia
p h i l i p r. l a n e , Trinity College Dublin and CEPR
j a c q u e s m e´ l i t z , Heriot–Watt University, CREST–INSEE and CEPR
d i e g o m o c c e r o , OECD
b e n oˆı t m o j o n , Banque de France
¨
e w a l d n owo t ny , Osterreichische
Nationalbank
xv

xvi

List of contributors

l ’ u d ov ´i t o´ d o r , Ministry of Finance, Slovakia (formerly National
Bank of Slovakia)
t h o r va r d u r t j o¨ r v i o´ l a f s s o n , Central Bank of Iceland and University of Aarhus
a t h a n a s i o s o r p h a n i d e s , Central Bank of Cyprus and CEPR
t h o´ r a r i n n g . p e´ t u r s s o n , Central Bank of Iceland
m a r t t i r a n d ve e r , Bank of Estonia
˜
j u a n a . r o j a s , Banco de Espana
l u i g i s p ave n t a , University of Rome and CEPR
z d e n eˇ k t u˚ m a , Charles University
d av i d v a´ v r a , OGResearch
s t e f a n i a z o t t e r i , Banca d’Italia


Abbreviations and acronyms

ABS
AIB
BCBS
BEA
BEPGs
BIS
BLS
bp

CBA
CCA
CDS
CEBS
CEE
CESEE
CPI
DGECFIN
DGSD
DSGE
EBA
ECB
ECOFIN
EDIRF
EDP
EEA
EFSA
EFSF
EFSM
EIB
EIU
ELA
ELG

Asset Backed Securities
Allied Irish Banks
Basel Committee on Banking Supervision
Bureau of Economic Analysis (US)
Broad Economic Policy Guidelines (EU)
Bank for International Settlements

Bank Lending Survey (ECB)
basis point
cost-benefit analysis
common currency area
credit default swaps
Committee of European Banking Supervisors
Central and Eastern Europe
Central, Eastern and Southeastern Europe
consumer prices index
Directorate General for Economic and Financial
Affairs (EU)
Deposit Guarantee Schemes Directive (EU)
Dynamic Stochastic General Equilibrium
European Banking Authority
European Central Bank
Economic and Financial Affairs Council
European Deposit Insurance and Resolution Fund
Excessive Deficit Procedure (EU)
European Economic Area
European Financial Stability Agency
European Financial Stability Facility
European Financial Stability Mechanism
European Investment Bank
Economic Intelligence Unit (EU)
emergency liquidity assistance
Eligible Liabilities Guarantee (Ireland)
xvii


xviii

List of abbreviations and acronyms

EMS
EMU
EONIA
ERB
ERM II
ESAs
ESM
ESRB
ESRI
EU
FDI
FDIC
FDICIA
FPC
FRB
FSA
FSB
FSC
FX
GDI
GDP
HICP
HP
IADB
IFS
IMF
INBS

INE
IPN
IT
LIBOR
LOLR
MAR
NAMA
NATO
NPR
NPRF
NTMA
OBR
OCA

European Monetary System
European Monetary Union (Economic and Monetary
Union)
Euro Overnight Index Average
exchange rate-based
Exchange Rate Mechanism II (since 1999)
European Supervisory Authorities
European Stabilisation Mechanism
European Systemic Risk Board
Economic and Social Research Institute (Ireland)
European Union
foreign direct investment
Federal Deposit Insurance Corporation (US)
Federal Deposit Insurance Corporation Improvement
Act (US)
Fiscal Policy Committee

Federal Reserve Board
Financial Services Authority (UK)
Financial Stability Board (EU)
Fiscal Stability Charge
foreign exchange
gross disposable income
gross domestic product
harmonised index of consumer prices
Hodrick–Prescott
Inter-American Development Bank
International Financial Statistics (IMF)
International Monetary Fund
Irish Nationwide Building Society
Instituto Nacional de Estad´ıstica (Spain)
Inflation Persistence Network
inflation targeting
London Interbank Offered Rate
lender of last resort
mean absolute revision
National Asset Management Agency (Ireland)
North Atlantic Treaty Organisation
notice of proposed rule-making (FDIC)
National Pension Reserve Fund (Ireland)
National Treasury Management Agency (Ireland)
Office for Budget Responsibility (UK)
optimum currency area


List of abbreviations and acronyms

OECD
OIS
OLG
ONS
PCAR
PCE
PLT
PPF
PPP
PV
REER
RFE
RPI
RPIX
RWAs
SGP
SITC
SME
SRR
SVAR
TAF
TARP
TFEU
TFP
TPO
UIP
ULC
VAR
VAT
WPI

Organisation for Economic Cooperation and
Development
overnight indexed swap
overlapping generations
Office for National Statistics (UK)
prudential capital assessment review
personal consumption expenditures
price-level targeting
production possibilities frontier
purchasing power parity
present value
real effective exchange rate
Federal Planning Bureau (Belgium)
retail price index
retail price index excluding interest payments
risk-weighted assets
Stability and Growth Pact
Standard International Trade Classification
small and medium-sized enterprise
special resolution regime (UK)
structural vector autoregression
Term Auction Facility (ECB)
Troubled Asset Relief Program (US)
Treaty on the Functioning of the European Union
total factor productivity
temporary public ownership
uncovered interest parity
unit labour cost
vector autoregression

value added tax
wholesale price index

xix



1

Introduction
´ ∗
Miroslav Beblav´y, David Cobham and L’udov´ıt Odor

This volume brings together the papers and panel contributions presented at the conference on ‘The Euro Area and the Financial Crisis’,
held in Bratislava from 6 to 8 September 2010. The conference was
hosted by the National Bank of Slovakia and jointly organised by the
National Bank of Slovakia, Heriot–Watt University in Edinburgh and
Comenius University in Bratislava. The event was characterised by intensive discussions between central bankers, academics and policy-makers
from all over Europe, which contributed directly and indirectly to the
authors’ revisions of their papers. The basic question was: What are the
implications of the financial crisis and the great recession for the future
of the euro area?
The book begins in Chapter 2 with the keynote contribution by Governor Athanasios Orphanides on the issues surrounding financial stability
in Europe. Part I addresses the experience of the crisis. Thorvardur
´
´
Olafsson
and Thorarinn
P´etursson try in Chapter 3 to identify the factors that caused the depth and duration of the crisis to be larger in
different countries. Philip Lane in Chapter 4 focuses on the Irish case.

Angel Gavil´an, Pablo Hern´andez de Cos, Juan F. Jimeno and Juan A.
Rojas in Chapter 5 examine the Spanish case. Aurelijus Dabuˇsinskas and
Martti Randveer in Chapter 6 consider the varying experiences of the
Baltic countries. Part II considers the issue of accession to the euro area
by countries in Central, Eastern and Southeastern Europe (CESEE).
´
Biswajit Banerjee, Damjan Kozamernik and L’udov´ıt Odor
in Chapter 7
analyse the different strategies for entry to the euro used by Slovakia and
Slovenia. Miroslav Beblav´y in Chapter 8 investigates whether euro entry
was associated with significant rises in prices (especially for non-tradable
goods and services) in Slovakia. And in the first panel contributions Gov˚
ernor Ewald Nowotny in Chapter 9 and Zdenˇek Tuma,
together with
∗

We would like to express our thanks to the discussants and all the other participants in the
ˇ
conference, and to Martin Suster
of the National Bank of Slovakia, for their contributions
to the conference and to the book.

1


2

´
Miroslav Beblav´y, David Cobham and L’udov´ıt Odor

David V´avra, discuss in Chapter 10 whether and how CESEE countries
should accede to the euro.1 Part III looks at the future of the euro area.
Francesco Giavazzi and Luigi Spaventa in Chapter 11 argue that much
more attention needs to be paid to current account deficits within the
European Monetary Union (EMU). Daniele Franco and Stefania Zotteri in Chapter 12 consider the role that national fiscal rules could play
in avoiding future problems. Thomas F. Huertas in Chapter 13 discusses
mechanisms for ‘bail-in’ as an alternative to future bail-outs of financial
institutions. Laurent Clerc and Benoˆıt Mojon in Chapter 14 review the
conduct of monetary policy in the euro area since the inception of the
euro and the challenges that the Eurosystem has faced since the financial
crisis. Boris Courn`ede and Diego Moccero in Chapter 15 assess the contribution that a price-level (as opposed to an inflation) target could make
to the operation and performance of monetary policy. This is followed
by contributions by Wendy Carlin, V´ıtor Gaspar, Stefan Gerlach and
Jacques M´elitz to the second panel (Chapters 16–19), on how to restore
confidence in the euro project.
Despite the different backgrounds of the contributors, there was a significant measure of convergence, and five important observations emerge.
The first is the need to reshape and strengthen EU governance. Governor Orphanides made it clear in Chapter 2 that alongside the important
topic of better prudential regulation and supervision attention should
be paid to governance issues, notably crisis resolution. The financial
crisis found the member states and their financial frameworks largely
unprepared, which led to chaotic resolution mechanisms and huge costs
for taxpayers. Orphanides calls for a unified EU resolution mechanism
based on three principles: limited moral hazard, fair burden-sharing and
cost-effectiveness.
The crisis also showed that one of the pillars of the monetary union –
the ‘no bail-out’ principle – was more wishful thinking than credible
threat for financial institutions and member states. Several participants
argue that this problem needed to be fixed, but there is no clear consensus
on how to do this. Huertas (Chapter 13) argues that EU countries cannot
continue to support large financial institutions, and advocates ‘bail-in’

rather than bail-out: he explores the creation of buffers at systemically
important financial institutions in the form of subordinated debt which
in case of emergency would be automatically converted into capital. This
would place the primary burden not on taxpayers but on the creditors
of financial institutions. M´elitz in his panel contribution (Chapter 19)
1

˚
Dr Tuma
was unable to attend the conference but kindly submitted his views shortly
afterwards.


Introduction

3

argues there is no need for no bail-out rules in EMU. Instead, as with
the states of the US, a national government could simply be allowed to
default, while policy should be limited to the construction and operation
of EMU-wide prudential rules for banks backed up by ECB powers to act
as lender of last resort. Gerlach in his panel contribution (Chapter 18)
takes the failure of no bail-out rules as given and proposes a mechanism that credibly promises a rescue, but at unattractive terms. Such a
mechanism would replace the temporary European Financial Stability
Facility (EFSF) and would contain significant automatic write-downs
(of 20–30 per cent) and strict conditionality, including pre-approval of
budgets.
The second key observation to emerge was a challenge to the models
scholars have traditionally used to think about monetary unions, with the
most heated debates concentrated on the issue of fiscal policy coordination. Several contributors put much more emphasis than the traditional

model on the issue of countries’ current account deficits. In particular,
Giavazzi and Spaventa (Chapter 11) argue that an important mistake
was made in the downgrading of the problem of current account deficits:
although monetary union eliminates the threat of currency devaluation,
high current account deficits can cause substantial problems if the proceeds of external borrowing are not used for ‘productive purposes’. In
other words, using external resources to finance investments in nontradables or domestic consumption can lead to problems in meeting the
intertemporal budget constraint. The high level of the former (investment in construction and housing) made economic success fragile in
Ireland and Spain, while the latter (borrowing for consumption) resulted
in increasing stress in Greece and Portugal.
This general argument, with its emphasis on country-specific conditions, is broadly consistent with the individual country studies by Lane
(Chapter 4) and Gavil´an et al. (Chapter 5). Lane argues that the long
Irish expansion actually involved two distinct periods: a ‘Celtic Tiger’
output boom fuelled by high productivity increases in the second half of
the 1990s, and then a property-driven boom period concentrated mainly
in the non-tradable sector in the 2000s. He considers the arguments
that EMU membership may have contributed to the Irish boom–bust
cycle, but emphasises instead the lack of appropriate policies in banking regulation and fiscal stabilisation, and the positive contributions of
EMU membership. Gavil´an et al. use a small open-economy model to
discuss the reasons for the emergence of a large current account deficit
during the period of strong Spanish growth before the crisis. Their analysis highlights the decline in interest rates due to Spain’s participation in
EMU, and the demographic changes resulting from the large inflow of


4

´
Miroslav Beblav´y, David Cobham and L’udov´ıt Odor

immigrants. Given these factors, in their model alternative fiscal policies
would have made little difference, while structural reform in labour and

product markets would have improved the growth rate but intensified the
external deterioration in the short run.
There is also some common ground here in the more general chapter
´
by Olafsson
and P´etursson (Chapter 3), which attempts to explain the
cross-country variation in post-crisis experience using a wide variety of
pre-crisis explanatory variables. They find that high preceding domestic inflation and macroeconomic imbalances, including large current
account deficits, are crucial in determining the incidence and severity
of the crisis, while larger banking systems were associated with longer
and deeper cuts in consumption and with a higher risk of banking or
currency crisis. Exchange rate flexibility tended to make the contraction
shorter and shallower, but it also increased the risk of crisis. EMU membership, on the other hand, did not entail the negative effects associated
with unilateral exchange rate pegs. In addition, Carlin’s panel contribution (Chapter 16) emphasises the issue of relative price levels as between
the different countries of the euro area: because nominal exchange rates
cannot be adjusted such differentials (which would show up in current
account imbalances) have to be reversed and eliminated (not just contained).
The third observation concerns fiscal policy. Bringing the problem of
current account deficits to the forefront does not mean that fiscal policy
problems are less relevant than before. On the contrary, several contributors highlighted the need to strengthen the Stability and Growth
Pact (SGP) and increase the effectiveness of national fiscal frameworks.
Gaspar in his panel contribution (Chapter 17), who also highlights the
challenges posed by demographic trends in the EU, argues that both market discipline (operating through interest rate differentials) and the SGP
have failed to ensure appropriate behaviour by national fiscal authorities. Major adjustments in the governance of the euro area are therefore
called for; these will include higher financial penalties and stronger conditionality on financial support to countries in difficulty. Gerlach in his
panel contribution (Chapter 18) stresses the importance of incorporating more automaticity in the SGP and replacing the existing inadequate
market discipline by incentives for governments to act with restraint: he
calls for a mechanism of graduated sanctions. Franco and Zotteri (Chapter 12) discuss the fiscal policy reforms which have been introduced or
are under consideration in different EU countries, with particular reference to current and ongoing German and French reforms and to fiscal
rules. Such national reforms need to be complementary to any changes at

the EU or euro area level, but they can contribute to fiscal discipline and