The Euro crisis: financial, monetary and fiscal stability
The Euro crisis: financial, monetary and fiscal stability
Pre-crisis received wisdom assumed financial stability would follow from price stability; the crisis proved otherwise. This presentation will argue that price, financial and fiscal stabilities are intertwined due to financial frictions. In downturns, optimal monetary policy should identify and unblock balance-sheet impairments that obstruct the flow of funds to productive parts of the economy. In upturns, diligence is required to avoid the emergence of similar imbalances. Closer cooperation between central banks, fiscal authorities and financial regulators on an international scale is needed to overcome current challenges.
burnable Mary Jo good afternoon and thank you very much for being here my name is lina pozole i am a journalist for the italian financial daily newspaper it's live in Tokoroa and it is a pleasure for me to introduce this debate with professor bruno meyer on a topic which is very important today and very much on line with the light motif of our festival that is thering relinquishment beyond the monetary policy in my introduction I would like to stress the very close relationship between financial stability and fiscal policy measures this has become particularly relevant for the eurozone crisis and for the international debate about the need for a higher degree of coordination to tackle systemic crisis and to prevent them a coordination between balance and budget decisions related to monetary policy and price stability these are three elements which we sometimes tend to keep separate one from the other in our analysis but really they're strictly connected one with the other so just a few hints to introduce the discussion referring to what has happened in Italy in the last two years as our president or the cabinet mr. letter was recalling yesterday there have been 28 international summits with heads of state and prime ministers who have tried to tackle a crisis that has frontally attacked Europe and the world in a totally unexpected way posing significant issues in terms of market regulation and budget policies as our prime minister mr. later recalled the turnaround was not due to an economic policy decision or a fiscal policy decision but rather the turnaround was due to a decision made by mr. Draghi president of the central bank and brother this was an announcement of the decision when back in August 2012 President Draghi paved the way to so-called unconventional operations ie buying bonds from risk countries on the secondary sovereign bond market and at that moment the spread decreased and anxiety decreased as well in relation to the different instruments we have to tackle systemic crisis given birth in Europe two important instruments such as the two safety funds of temporary and the permanent one and and this is one of the topics I would like to attract professor Bruno Myers attention on to the launch in Europe of a project for a real banking union monitored by the European Central Bank so these are the topics that will be addressed by the European summit on the 27th and 28th of June to shift the attention now towards the rest of the world I would like to say that worldwide there is the need for a high degree of integration integration between the decisions made by central banks and the decisions made by fiscal bodies in the United States ever since Lehman Brothers went bankruptcy there has been a lively debate on instruments to prevent the collapse of banks and in Europe there has been a very important impact and many countries had to increase a public debt to support and bail out banks so integration there's something fundamental it is necessary and as an observer to be honest I haven't seen one single direction either as far as Europe and as far as the world is concerned that indicates the way to go that is how will economic policy decisions interact with monetary policy decisions as well as decisions on the stability of the financial system professor bruno meyer is a well-known expert in these topics he has reserved specifically financial markets and macro economics with special attention to liquidity financial bubbles financial stability and the way how all these factors can affect the ruling or financial markets and monetary policy so without further ado I would like to leave the floor to Professor Brunner maíam who will give a presentation that will be followed by a debate so feel free to ask your questions I shouldn't be here and give have the opportunity to present something present my work here so it was indicated I would like to talk about the interaction between the different stability concepts a bit in financial stability there's no financial crisis price stability that you want to avoid deflation or inflation and fiscal debt sustainability which essentially says that the government should be able to pay back its debt and should be sustainable in the long run so additionally you have this three stability concept financial stability price stability and debt sustainability and before the crisis it was thought you have essentially always won a actor in charge of an interest ability Putin's policy and bank supervisors are in charge of an interest ability here of the central bank's being in charge of Christ's ability and the fiscal policy actors like the government's there should be in charge of debt sustainability so essentially have along this diagonal that's where this assignment of the task was assigned what was ignored and actually all these three measures interact quite a lot and I would like to show you how they interact and what are the mechanisms how they interact and what are the challenges and for the different players who have to coordinate then in order to avoid a Wars outcome if they're compared to a situation when they don't coordinate so in particular what I want to focus on first is that there's some amplification mechanism going on within the financial sector what do I mean by amplification mechanism amplification mechanism is there's a small shock and then this small shock leads to a large implication it's amplified and makes the whole thing much bigger so a small initial trigger can lead to large dislocations typically the way it works it works to liquidity spiral if I look at the balance sheet of a bank of a particular Bank banks typically have government bonds they have some other assets they also give some credit and if there's a negative shock to any of these assets they're cut back and how much credit they will give and this also hurts the funding position it's much more difficult for them to fund positions and there's actually leads to lower asset prices again so there will be this liquidus Bala will come back to this later again of course it makes a balance sheet more risky so the moneyness of the debt is going down the banks also issue some money so then how they fund themselves is this entry through deposits and deposits our form of money and we will come to this in a minute what I want to do first I want to show the interaction between financial stability and price stability traditionally it was thought before the crisis especially during the Great Moderation where will the body thought everything is safe that as long as yours I have a price stability secured the financial sector will be sound unsafe as well we know now there are close interactions between the two stability concepts and I want to show you one mechanism how it works and typically the way it works is that whenever there is a crisis in the financial sector the financial sector will shrink the balance sheets so the total money supply in the economy is actually going down and this leads to deflationary pressure then actual deflation increases the real value of the debt which hurts a balance sheet again move that the first mechanism we will walk through the slides later on I will show the other mechanisms which lead to inflationary pressures and you will see in times of crisis deflationary pressures and inflationary pressures will be very powerful and it's very difficult to keep the balance between the two forces okay so let's first start with interaction between financial stability and Gaya stability through the official deflation spiral so essentially to do this let's just start with a simple economy there is stylized economy and let's say there is only risky lending or direct lending so some empowers some guys some firms have some good idea they want to produce something and they want to raise some funds from some savers who have some excess funds they want to save something and the savers can buy some risky claims from these firms who produce something I can also hold some outside money the outside money is given by the ECB as we will see the two types of money there's outlet money and there's inside money what I mean by that how that money is money created by the central bank by the ECB for example in that money is the money created by the banking system inside the system it's not coming from outside it's not coming from the government it's created by the banking system like the amount deposits if you have something more deposits in your checking account in your bank that's inside money it's not created by the ECB it's created by the banking system so here I'm talking about a world without banks I will introduce banks in a second step where there's only outside money you can only get it's a whole cache which is you know issued by the ECB so it's actually your choice here is as a saver if you're one of the savers to lend some money to your friend you know your friend wants to buy a house or wants to start a company and that's quite a risky because this company might not do so well he might not pay back that's one choice and you know each of you guys let's say you use the savers you the entrepreneurs and each of you one of you can actually lend some money to one of on the other side or the savers can also holds a mouth that money and they can split it up the way they want to split it up now let me introduce banks so we can also introduce banks or intermediaries who step in between these are the intermediaries now the picture looks a little bit more difficult because we have also this banks floating around so the banks they can actually lend some money to these entrepreneurs remember you the entrepreneurs here or the guys want to buy a house the end bonus and the bank sold risky claims now towards them and issue some inside money that's a monitored amount deposits or any other debt you should buy the intermediaries which again is held by the savers and banks have also some net worth is an equity so the balance sheet here on the asset side he have claims towards the entrepreneurs on the liabilities they have some insight money the amount deposits or other debt and some equity so there's some debt issue and there's some equity issue let's assume the equity is primarily held by the bankers themselves okay so if you say about what you can do you can save inside money well outside money which actually is the same for the whole cash or the mod deposits or you can hold the risky claims directly but essential for holding inside money you indirectly hold risky claims and so why do we go through this indirect channel and not just directly to the direct channel banks have some advantages that lending doesn't have in this framework to the bankers for example taking diversify across this end for us so if there's some bankers taking actually across these entrepreneurs that can diversify while you individually you cannot diversify you can't just hold a portfolio of all these investments and secondly the bankers might also be better in you know monitoring what's going on here in order to make sure the mortgage is paid back okay I can go off the utica and force much better than individual households that the debtors actually can paint that back their money so these are the two advantages bankers have so on this leads to more efficient lending if it's done through the banks rather than direct lending of course if this was our big cooperations they can also issue direct commercial commercial paper also corporate bonds so that's less of an issue but for smaller firms it's way more efficient of course with the bank lending and in Europe in particular a lot of the lending is done through the banks now what I want to do is so that's the framework what I want to do is I want to shock the system now there's a negative shock because the subprime crisis in the US and some of the bankers I exposed to it all for other reasons there is a negative shock and I want to split up this negative shock into three steps okay of course in the framework everything will occur simultaneously but let me split it up into three little sharks and then see how this whole thing feeds and amplifies so the first chalk is there some thumbs up to the empowers the films are certainly less productive or some of these mortgages are not worth as much as unary thought because they're subprime mortgages in the United States or other mortgages house pairs in Spain are going down they're now more risky so what you have is that this risky claims the bank has had an hour worth less so that's why I reduced the size of the box a little bit okay of course the demand deposit of the bankers is not going down it's still the same so that I abilities is still the same so everything has to be absorbed by the equity portion here okay so the net worth or the equity portion of the bankers is going down so you see they're highly levered so any risk a small 5% drop here will be much more drop here on the equity side it's opposed to equity haft here it's roughly half as much as before if nothing else happens in the system if there's just a negative shock but then it just means that the bankers are twice as leveraged as before what is leverage leverage is the size of this box relative to this box how much is equity financed and how much is that financed so that's the first part of the shock and if there's no behavioral response to that that's it okay and nothing would happen but what happens as a response of this now the banks are much more levered that twice as much level as before they all try to shrink the balance sheet okay how do they try to shrink the balance sheet is just about to get rid of these risky claims okay so everything is the same as before now they want to get rid of this risky claims in order to get the leverage back down to our level which is closer to the one before the shock occurred okay so now what they can sell it the banks can sell there is it claims this mortgage claims to each other but you know this wouldn't change at all but if you really want to fire sell to somebody they have to sell it to the savers okay but the savers are not so good in holding these claims because they cannot diversify and they can actually not molitor's a well as scan so the Sabres are not willing to pay much for this risky claims because in their eyes it's very very risky okay so the price of this risky claims is dropping there's this fire sell this liquidity spell I was talking before is amplifying the whole thing so there's a huge amplification going on even if to sell a little bit the price of the subsidy claims is going down quite a bit and that's actually you know amplifies and makes the whole thing even further and more of the equity is eroded okay that's the second step notice by freaking the balance sheet that towards a second thing second thing is they also shrink the total size of the demand deposits okay so on the liability side the inside money is going down too so what happens on top of it total size of outside money means that man is actually going down and this means if total money supply in the economy is going down there's deflationary pressure okay just deflation because now the value of goods is actually going up to this deflationary pressures monies were subtly more so because of this deflation the value of money is expanding so you have this money box the liabilities are expanding and that hits the bankers again on the on the equity if the bank's equity is actually shrinking even further so let me say this again so the shrinkage of the balance sheet because people are freaking the balance sheets so total money supply is shrinking relative to outstanding goods if nothing else but to change there's deflationary pressure the value of money is going up but for banks the value of money's on the liabilities well it's part of their liability so that debt level is actually going up in real value okay so that's why the net worth is actually shrinking even further so they actually that's a third effect so you have first the initial shock then you have this fire sales amplify this whole thing the liquidities spiral on the asset side of the balance sheet and then try to shrink the parent sheet by shooting the balance sheet they also shrink the total money supply which is deflationary pressure which hurts the bank's again when the equity is going down even further because that's expanding the only way you can expand is just by eating into further into equity okay that's the third effect and you can see already how the initial shock and the liquidity spiral and responds to shrink the balance sheets effects and price stability in this case it's deflationary pressure okay so that's essentially summarized in this slide what you have is after the mattress shock the immediate net worth think of Bank equity is going down they will try to fire sell some of these realistic claims the price of this risky claims will go down because you fire sell it to somebody who is not so good in holding these risky claims we cannot do both households cannot diversify okay not monitor as well so the allocated efficiency is actually going down that's the liquidity spyler was talking about beforehand now top of it because the shrink the balance sheet the lending is going down and the number of deposits is going down because to shrink the balance sheet all instead of you know just hauling the meat just Park the deposits in the ECB that means the value of money is going up or in other words no goods are getting cheaper deflation is kicking in the money multiplier is actually shrinking what do I mean the money multiplier how much is money is given from this central bank relative how much money is created by the banking system the fraction of money which is created by the banking system is actually going down okay so you saw in the crisis you saw collapse of the money multiplier across the world everywhere the money multiplier was collapsing less money was created by the banking system it just came down and this causes deflationary pressure first in the u.s. there was this deflationary pressure and in Japan it's already for a long for two decades at this deflationary pressure going on here because of this value of the liabilities of the banks are expanding to the banks and hit on both sides of the balance sheet the initial shock on the asset side and then through deflation on the liability side asset shrink liabilities expand both is bad for the banks and all this risk is just triggered by a small initial shock because of this leverage in the banking system it is amplified so a small shock can amplify things risk is generated by the system endogenously that's why it's oft referred to as endogenous risk it's generated by the system on its own a small trigger can lead to large changes in the risk now so that's essentially what's going on here just throwing here again what we had before there's this initial shock it can be these other assets where there's some shock and this leads to if these banks were to raise new equity all these things could be switched off if you can force the banks you know you lost on equity instead of shrinking the balance sheet raise new equity issue new shares then all this amplification is switched off but if the banks refuse to issue new equity which has guns under the term financial dominance then actually all the sample fish amplification is going on so you have the money supply shrinking as we had before on this deflationary pressure and of course with money supply deflation is kicking in the real value of the money is expanding so you have this official deflation spiral and situation is getting worse and worse now what can monetary policy - or what can one do so as I mention already one thing you can do say to the bank's you issue new equity you just have to issue new equity you're not allowed to bring a balance sheet our current regulatory framework is such that you have to have a certain minimum equity but it's specified in percentages you have to have at least 7% of equity relative to total assets if you have 100 euros dollar an asset you have to have seven euros in equity if you violate it what can you do two ways you can either sell you assets or you can issue no equity so let's suppose you have 100 euros equity at total assets but you've only 5 euros on equity you can go out and issue new equity raise another $2 then you find again or we can say ok let me just sell some of this assets such that I have 7% of equity there's a huge difference between the two things from a bank's perspective it's not so different but from an economy-wide perspective it's very different the first approach were you issue new equity you don't have to fire sell any assets in the second approach you will fire sell assets and this actually to this dislocation and this deflationary pressure I was talking about before of course you can do something else you can also just hand the bank as a bailout okay so all you undercapitalized there was this negative shock now your equity is too low I just give you some money as a present okay and to some extent you can redistribute wealth and it might actually be good because you stimulate the economy and the economy is going better and one might argue that's what monetary policy does to some extent you redistribute wealth so you figure out in the economy here for example the banking sector which sector is undercapitalized is underwater and suffers from a debt overhang problem like if the banks suffer this negative shock they will not give new loans this will hurt the economy so they suffer from debt overhang problem there's too much debt relative to the total assets now how do you redistribute this wealth one way you can do that is by saying the central bank is buying the assets this particular banking sector is holding what are these assets for example long-term government bonds if the banking sector is holding a lot of long-term government bonds and suffer the negative shortcuts else on mortgages you just go out and buy long-term government bonds and cause a positive shop to offset the negative shock that's one way her monetary policy works how does what's monetary policy when I pause it you said you change the interest rate and you through open market operations you buy some government paper long term paper if you cut the interest rate the short-term interest rate the value of a long-term bond is going up imagine a bond which pays 10 euros every month for the next 10 years if the overall interest rate is dropping the bond which pays off 10 euros every month is in value is going up so whenever the banking sector suffers some negative hit and then it's amplified and deflation kicks in and all this what does the central bank do the central bank cut the interest rate and said ok now you the bank exactly has a positive shock which can offset the negative shock and then we can switch off all this amplification which are talked about before ok but essentially it is a way to redistribute wealth from the non banking sector to the banking sector ok you can also do this go first injection the fourth bailout in the banking sector but that's how you could for example recapitalize or that's how typically bank monetary policy works in a redistribution framework now you might say that's really bad it's like an insurance scheme for the banking sector whenever there's a positive shock you know then we increase the interest rate which means we lower the value of the government bonds that's a negative shock offsetting negative shock whenever there is a negative shock on mortgage paper we lower the interest rate in order to create opposed to show up on government papers ok so that's like monetary policy is essentially a big insurance scheme for the banking sector and like any insurance scheme this leads to something like moral hazard what does moral hazard mean it means that you know if you what you do you don't be at the full risk because somebody else provides insurance and then it is towards your behavior you are willing to take on more risk because some of this risk will be offset if something goes wrong by the central bank that's why you have to be very careful a central bank and that's why you would like to have some measures which prevent the banking sector from taking so much risk and the bending sector naturally has the tendency to take on more risk because whenever something goes wrong the banking sector knows the central bank has to cut interest rate and then essentially recapitalize the banking sector and that's what we have all these macro prudential measures that's a new heading under which they're running that saying you know you can only take on so much risk there has to be certain loan-to-value ratios they have to certain restrictions in order to make sure that the risk is contained now that's essentially the old picture again so that's essentially what I was just elaborating the linkage between financial stability and price stability if you have a negative shock you have this fisher deflation spiral in the absence of any monetary policy reaction so in the first step what I told you was this balance sheets essentially there was no monetary policy reaction it was just like under the gold standard so they're just negative shock and then it's deflationary spiral if the central bank can count the actors that can switch off this deflationary pressure and then avoid this amplification of the initial shock remember there's a small shock then it's a liquid a spiral the assets value drop much further deflation spiral liabilities are going up both amplifies initial small shock to a traumatic large big shock if the central bank can offset the small shock negative shock with a positive small shock all this amplification is mitigated it's much less dramatic now let me add now debt sustainability let me add the physical authorities the government's who decide about the budget or how much debt should we have as a government if I add this third dimension to it how does the whole picture change and that is of course what's often referred to as a game of chicken when there is a negative shock they are net their losses and the question is who should be are these losses and you can say the bank's so the equity hold or even the bondholders of the bank should bear the losses that's one outcome or you know the government can bear the losses fiscal expenditures or the central bank can be are the losses and then this entry which are ultimately leads to high inflation okay and I want to illustrate this diabolic loop between banking risk and the government risk and there's a lot of talk in the euro crisis about this diabolic loop so now don't be scared about this picture I put everything together so we still have this old picture here there's a liquidity spiral we had before we have official deflation spiral I was just explaining before and now I add this diabolic loop which is like this red dashed diabolic loop here okay so let's go through the story again now with a banking sector and also with fiscal debt sustainability what was the difference between what I was talking so far and what I will talk now so far was assuming there's no risk that the government is defaulting so the possibility of a government default was zero I heal X naught this assumption and say oh it could be if the government has too much depth it could be that the government is defaulting and how will this play out once allow for this possibility and that's when the parabolic loop is coming in okay so again there's this negative shock let's say to the other assets that would be the fire sales and all this but and this causes this deflationary pressure on the fourth it also leads to not to give new loans so the credit supply shrinks the banker says wolf I'm already so leveraged I shouldn't give any new loans on new mortgages to households who want to buy a house or to some firms who want to start some investments so credit supply shrinks so because square in supply shrinks GDP is shrinking so total productivity and economy is shrinking due to the scary crunch and also cause the whole economy does much Monserrat t so everybody withdraws on investment so GDP is going down as GDP is going down the tax revenue is going down and the banks are anyway in trouble so the probability that in the bank bailout is going up both is actually bad from a fiscal debt sustainability perspective okay now there are three ways out so one way out is you know the government is actually in a bad situation is not well it can in the long run it has to cut expenditures and perhaps not immediately because you know starett II might be counterproductive you in the long run you want to bring the expenditure to GDP ratio in balance again that's one thing so if the central bank is in the driver's seat if there's monetary dominance and the central bank can impose on the physical authorities you better put in your house in order then that's one way to go the other way to go is to say okay the monetary dominance the central bank is not mitigating anything the central bank is refusing to give in but the fiscal authorities are also refusing to cut the expenditures so if both of them refusing to cut expenditures what's going on then then the likelihood that there will be a default and government debt is going up and government is not cutting back on expenditures the inflation the central bank is not allowing inflation the third way out is default there are losses in the system it has to come through inflation it has to come through lowering expenditures down the road or government default so if there's possibility of default is going up the value of the government bonds is actually going down and the risk premia is going up and this means because the bonds are held by the banks the total value of the assets of the bankers is going down even further of course this feeds again in this liquidity spiral which feeds again in this fish of deflation spider okay so if the center bank is not giving in so then you have to stab Olli gloop moving around here and this of course feeds amplifies further here and also amplifies further here so you have about three type aaalac loops which all feed on each other you can see that a small shock can amplify to a much much bigger shock down the road now you might say okay let's go for another scenario where you know there's physical dominance so the physical authorities say we don't cut in expenditures down the road perhaps not right away but even in the future we want to it and the Bala territory is very weak then there are the outcome is inflation and that's what I mean by this game of chicken game of chicken between fiscal authorities and the central monetary authorities or the central bank who is giving up who is blinking first that's what's going on in Europe the big time and across the world fiscal authorities they don't absorb their losses they want to sit down the road we want to cut expenditures and on the other hand the central banks don't want to say oh we allow for inflation to absorb the losses but who is blinking fast whereas the compromise down the road so when the physical dominance kicks in then you will have high inflation and then of course you have something which offsets this deflationary pressure so times of crisis in normal times you also have a little bit of deflationary pressure you can also have a little bit of inflationary pressure but in crisis times the two forces become very powerful you have one force pushing into deflation and another force pushing into inflation so both forces are very powerful pushing in the opposite direction so what you have is that at times of crisis to balance these two forces very very difficult it's a huge challenge to balance these two forces the system is very unforgiving to small mistakes if you make a small mistake or some certain bargaining is not working well then the system drifts off to one extreme or in the other extreme you might end up in a deflationary spiral and your huge deflation and the whole economy restarts you might also end up in a huge inflationary environment okay and I compared it a little bit with the bicycle driver who drives on a bicycle as long as the speed of the economy the speed of the bicycle is fast enough it's very easy to keep the balance between your left and right on the bicycle but in deflation and inflation but when the in speed of the economy slows down becomes slow and slower then you either drop off left or right you might not know which way you will fall but you know you might fall okay and you can see this if you look at different inflation expectations there's some guys in the market places at all we move into deflation really things are getting worse debt overhang is getting much much worse or other thing of wow we're moving back to Weimar in a high inflationary environment and you can see this in the market place in the inflation expectations and the difference in the inflation expectations so so far I haven't said anything about a currency union so far this could have happened in any single country right just want to say what is the complication once you have one central bank and multiple countries okay so let me just spend few minutes on that so the first thing is you have this cap of flows across borders and I will illustrate this in a minute and instead of having this game of chicken between one central bank on what physical authority you have now this game of chicken between one central bank and seventeen fiscal authorities or 17 governments which makes the whole thing even more complicated much more complicated who should absorb these losses which of these fiscal authorities and the central bank let me first jump into the capital flows and let me just give you a stylized picture how the run-up of the crisis works not just be two countries Spain and Germany being in Italy might be neutral to do that and the way you can think of it's the following schematic way this flows before the crisis there's a Spanish homeowner a Spanish builder he wants to buy some elevator or some dishwasher and I am victus numbers you will see that this examples in a minute and there's some German firms who you know produce this elevators or dishwashers which are then built into Spanish houses in Spain and of course Spanish homeowner builder finances says it goes to its his bank and says ok how does it have fun this or you get the loan for mas at a certain interest rate which is floating interest rates in to say can go up and down depending how the market situations are changing and part of this the Spanish bank is funding it through the Spanish savers but most of it the Spanish bank is funding it through the interbank market says all we need more funds in order to give the Lonestar Spanish homeowners because of the interbank market with some German financial institutions are essentially providing the funds their success saving in Germany and that gives it to the interbank market to the Spanish banker and then this lends it the Spanish bank lends it on to their Spanish homeowner and then as of course the German saver who gives its deposits to the German bank is German bank Basel on the Spanish bank and so forth how this payment for the dishwasher the elevator is paid to this bank of the producer of this and then of course then the wages are paid to the German save and that's how the whole situation works and everything works fine for a long time and more and more elevators and dishwashers are burned what's important is this is invested in some housing which is not very movable okay these are housing is a collateral but it's Spanish tearing out the dishwasher or the elevator is quite very destructive okay destroys a lot of value now what happens is when the market breaks down suddenly does the interbank market doesn't work anymore than the Spanish bank which funds to the Spanish homeowner Spanish homeowner has to pay every month a certain amount and it says whoa the Spanish banks we have no funding anymore what should we do we will charge a higher interest rate and because it's short term funding short-term loan funding but then the Spanish thinks I you have to pay the Spaniard you have to pay for your loan spell it oh I can't anymore what you can do is you can take out the dishwasher or it can take out the elevator and fire sell the elevator essentially to the Chairman saver that's the only one you can sell it to nobody no bank wants to have this let's end this physical good which saved so if this collateral can be sold off to the chairman saver but of course the Chairman Savea is not willing to pay much for a used dishwasher moving attack from Spain to Germany so there's huge value destruction you see how huge losses are coming up from this thing so what what's happening is that oops you know the interbank market breaks down easy pieces all this is just ematic how the losses will come up there how much Valley destruction there is in the system this V Thompson and there's okay instead of the interbank market the Chairman financial institutions can actually Park the money with the EZ P and then the easy P is actually lending to the Spanish bank okay so any risk now which is you know with this risky aspect here the German banks don't pay at the city anymore the risk is not born with ECP so if this is really insolvent then they losses go over to the ECB and that's like one in this game of chicken where the ECP's assuming these losses is you know then leads to inflationary pressure okay now as I mentioned already this game of chicken to the power of 17 essentially you I think how can we solve this problem so though the Spanish banks are risky we have to recapitalize this banks okay so the Spanish authorities have to go to the taxpayers and recapitalize the banks who is absorbing the losses the Spaniards okay or we can say you know be part on the losses to the ECB who is absorbing the losses the guys hold a lot of nominal claims if you look at this survey the Germans haul a lot of nominal claims all their savings is in nominal claims most of the wealth in Italy in Spain is in real estate there's not much nominal claims it Germany a lot of the wealth of the median household is in nominal claims that's why the Germans are so risk-averse against high inflation because the older savings is in money and not in real estate most are renting their houses so that's one thing now you can say you restructure the Spanish banks you can wipe out the equity of the Spanish banks this of course will hurt the Spanish equity holders which are probably mostly Spaniards you can also default on the Spanish banks you just declare them as bankrupt then the German banks which were lending to the Spanish banks they lose that water was whatever lending so the Spanish German banks will suffer from that or if the ECB was already stepping in it will be the ECP losing out on that and it depends how early you default if you default very late then it sentences ends up in easy peas hands and you might also have to recapitalize than the German banks so the german taxpayers on the hook okay and as i mention already before these be the finances banks at the low grade and then it's the case that you know it through high inflation who is actually suffer from this the most these are the guys were all mostly nominal claims so we have here I just pick two countries here there of course are 17 countries you can see if you go one of the off these options it is mostly at the expense of Spaniards if you go for one of these option it's mostly at the expense of Germans and what's going on in the euro crisis said everybody says wait a minute and perhaps there's some hope perhaps the situation improves again then there are no losses and then you know I can we can grow out of this losses or there's a chance that you know somebody else will absorb the losses so the Germans are waiting for the Spaniards to absorb the losses the Spaniards are waiting for the Chairman to absorb the losses and at the end more of these dishwashers have to be taken out of these houses and fire sold to the Germans and the losses accumulate in the system okay so I'm doing with time five minutes okay so that's what's going on essentially so you have this huge problem in the system and you have this capital flows which initially build up and this capital flow is very you know these are all houses or some durable goods which are not easily resold or if you fires on them that they will want to be sold at a huge discount the other element you have is that you have a lot of capital flows back to Germany so in the in the Orlan days all this capital through the painting system was going out of Germany into Spain now everybody is scared that you know this is becoming more and more risky because of this amplification everybody wants to bring the funds back to a safe haven so there's a lot of shift back of capital flow back to Germany to fly to safety okay so you have more flight to safety going on so what happens is today that the value of German debt is increasing and that's the case it's even increasing even though Germany is getting less safe but what matters is relative safety so if you look at something like Syria spreads which are insurance products to insure against the default of Germany it's also more expensive to insure yourself against the default of German tapped because German is getting more risky as well because assuming all this and liabilities through target2 and other measures so if the guys whenever the guys's gets more dramatic but then you have to the value of this Italian or Spanish debt is going down the spreads are widening and for Germans pair is actually the interest rate is going is going down so they in the Italian and Spanish interest is going up interest rate is going up and the German interest rate is going down now how can you solve this this problem that you have this flight to safety across borders okay is there a way to we design the system that you don't have this fly to safety across borders so you're you know funds flowing out of Spain into Germany when the situation it first it was flowing the opposite direction and then it flows back can we redesign the system in such a way that we don't have this across the border flight to safety so one thing is what I was often debated is the euro bond you know let's just make all the points the same and if something goes wrong in Spain is the Germans you have to pay for it as well so essentially there's no Spanish pawned anymore there's no German bond anymore and as it's been she only the euro bond so they are all treated the same there's no reason to have any flight to safety anymore and of course it also distorts incentives you might go into higher higher debt level knowing that the other country has to pay for it and that's of course hugely problematic my German perspective another way of doing this is what Lewis caracarno and others we a proposed rule so-called European save bones or ESPYs and the idea is the following you have a European debt agency which buys up a fraction of the Spanish bonds a fraction of the Italian bonds a faction of the German bonds and so forth altogether and pulls it together on the asset side of this balance sheet of the European debt agency and then it issues two bonds a senior bond and a junior bond so the senior bond is here and the junior bond is here what's the difference if their loss is on this side the junior bond is hit first and protects a senior bond okay and notice there's a negative correlation on the asset side whenever the crisis becomes more severe the value of the German bond is going up the value of the Spanish bond is going down so they always move in opposite direction so there's very good there was vacation on the asset side and there's negative correlation on among these bonds which again protects the senior bond now instead of having this capital flows across borders you will now have the capital flows across the jr. pond to the senior bond so instead of having flight to safety from Spain or Italy into Germany when the Connecticut was on the opposite direction when the crisis assumes now you have flight to safety from the junior tranche or junior pond to the senior pond both the European bonds okay so here from one European entity like a junior European bond to a senior European bond and there's no flight to safety across borders anymore so you redirect the fly to safety across borders from some European unit to another European bond unit so this way you redirect this fly to safety and you stabilize you bring this the yields down at at an espera foreign countries and of course it will also move up the yields of the Chairman pong buns some extended trust will equalize it but that's done without any joint liability it's never the case that Germany will be liable for Spanish debt over Italian debt so it's way more easy to push through the German Constitutional Court it's just through a bond structure we just redirect a flight to safety capital flows so let me just conclude when I try to squeeze a lot of material into this short presentation what I wanted to convey here is two things first all these three stability concepts financial stability to avoid a financial crisis inflation / deflation risk is highly interlinked and it's also highly intellect with fiscal debt sustainability these are three separate stability concepts which initially economists thought can be treated separately through three different agencies but we can't separate these tasks so nicely and these agencies have to work closely together to do that monetary policy can help to avoid this deflationary spiral and the way it works is it essentially capitalizes banks in times of crisis we call it a stealth recapitalisation it's a sneaky way of recapitalizing banks you cut the interest rate and by cutting the interest rate you increase the value of the long-term bond they are holding on the asset side there's a negative shock on mortgages you cut into it and this cutting into said leads to a positive shock and government paper and the negative shock is partially offset by positive shock on government paper and this helps there's a game of chicken going on once there are losses in the system if there are no losses in the system if it's purely liquidity problem find multiple equilibrium problem is a liquidity problem then we can solve for its end the pain can just solve it but if the losses in this system then a game of chicken stars who is absorbing the losses there's seventeen fiscal authorities and there's one central bank who will absorb the losses and the longer you delay this decision who will absorb the losses the more the losses will accumulate the more losses will arise in the system but of course everybody is trying to push the losses on on somebody else and that makes the losses bigger and bigger now nobody wants to resolve the problem upfront and as I mentioned this leads to the strategic delays and makes things worse then I mentioned finally this European safe bond which allows Andry channels to fly to safety from the southern countries to Germany to have instead of having flight to safety across borders you have it across the jr. bond to the senior pond and both bonds a European bonds so it's from one European unit to another European unit so let me leave it at that and we think we can go to the Q&A pod thank you dimande professor laverra channel probably there are many many questions professor byrne Amaya I would have many questions to ask myself but perhaps we were to collect a few questions and then I'm going to give you the flow back don't you think that this game of chicken that you refer to us about and that you presented presented very with great detail don't you think that this game of chicken it somehow is somehow urging or pushing towards the de facto change of the role of the European Central Bank don't you think that the role is changing because of this game of chicken during this major crisis affecting something that in Europe the European Central Bank has changed its mission it used to be somehow the Guardian on the stability of price in controlling liquidity on the market and now the rule role for the ECB is that of a lender of last resort the second question that I'd like to put is the following and that has to do with a new net worth requirements for the European banker because of the power three agreements do you think that these new requirements for banks may have repercussions may have a negative impact on the financial stability as probably is one of the risk that we run in that and then the third is more of a political question you talk to us about this possibility to have either euro bond or stability bond or in ESPs or whatever we call them don't you think that after the elections in Germany to be held on September next don't you think that they go to be a further acceleration in terms of decision making towards this direction these are the three questions that I have myself and then probably we're going to take a few questions from the floor if there are any so the discussion is open to questions from the floor my name is Giovanna van Feeney I have a question as a matter fact I have a couple of questions one has to do with Jacinto or et an Italian economist who died recently and I'm a strong supporter of his ideas he was raising one question who does the European - who does the euro belong to because we might pay people in Naples or to print false money and that would cost much less the euro as minted by the BCE by the ECB costs much more than the money printed by forgers in Naples I believe that you know the John Perkins writing the confessions of a killer there's a very nice documentary that was shot - by somebody from South Sea roll together with another young man from Austria talking about the Brussels business so who does Europe belong to who does this unum belong to because it seems so that there are international lobbies in it that are exercising pressure on the European market so don't you think that John Perkins is writing that we are black made by international lobbies which is to affect the European market and most specifically there are lobbies coming from the US so that negatively impact the European market but separately loop diabolica and a pallet on K Derrick are presented to Jennifer you spoke at a diabolic loop how can we break this loop that brings banks to become indebted with sovereign states and sovereign states have a huge debt I mean how can we break this vicious circle another question this was exactly what the professor's just try to explain it so this is my question as an alternative to you Rubens do you believe that we could have the European Central Bank to buy in the secondary market they could announce a program to buy the bonds of all you rule and governments at least 60% in ten years five hundred billion per year and in this way we could break the diabolic loop that you mentioned and this can be done immediately and all southern countries after all have agreed with the fiscal compact so nobody feels Germany any longer well we have a collected a total of six questions so I believe we should leave the floor up to our speaker for the answers and then we can see perhaps if there are any other questions okay thanks a lot for the questions so let me start with with the game of chicken you see role of the ECB changing and I think it is changing in the easy piece of course very well aware of the problems that everybody tries to push the losses on to the easy piece balance sheet and that's and you know these people hold the back and that's why we have OMT I mean the conditionality Draghi tries to impose on the government's so again I we cannot up these we cannot absorb the losses without fundamental changes in the expenditure structure down the road if these we would buy bonds directly without any limit and without conditionality then the governments would have no incentives to change the expenditure structure down the road or to take measures which boost GDP growth down the road and then dzp will be in deep trouble suffering losses and essentially the only way out is through high inflation generate income through high inflation and inflation expectations will pick up and that's the ECB is very worried about that and rightly so on the second question was about the Basel three required and yes there are new requirements there's a phase where you can push phase in there's new requirements the big problem with the requirements as I mentioned in the voice is entry they are all in percentage terms rather than neural level terms so you how you can satisfy these requirements you can shrink the balance sheet and a shrink in the balance sheets by not giving you credit you make the situation even worse you don't give to small and medium enterprises any new money new loans and they call me I can't go anymore and this of course makes the existing loans more risky and it makes it whole situation even worse and that I Pollock loop kicks in on top of that so what you really want is you would like to have some requirements which are based on euros which force the banks to issue new equity like the rich bank was just issuing for the billion euros so they have to be forced to issue new equity rather than to fire-sale existing assets rather than stop lending on the small companies they have to issue new loss absorption absorbing capital so the question was about ESPYs about politics yeah so it's of course you have to that's what the lobbying aspect comes in to of course by issuing new equity you dilute the existing shareholders now they don't like that they're like to have this absurd option value and buy a new equity the existing share price will go down and of course there's huge lobbying pressure that you don't go down the road but the question is what is good for society and what is good for the shareholders of banks and you have to push essentially what's good for society and you have to force them to issue new equity and at the moment we don't have the legal framework to really enforce that and that has to change whom does you belong to the Europe alongs to the citizens it's definitely I mean it's it's European money and it should belong to the citizen of course it is feared money it is an abstract concept and one has to design it well such that it's not ruled by house of lobbyists and that's where you have to see where the connection between the banking system and monetary stability comes if you treat price stability totally divorced from the banking system as we have done beforehand you don't see that you know you need some strict bank regulation and enforce let's say issues of new equity in order to have a stable euro which belongs to the average citizens and it is essentially pure who save in terms of nominal claims that's why I have to God against being this the value of either deflation which is bad which makes the whole system was also high inflation in post scenarios you have to make sure that it's not going out of hand how do you break the tie Pollak loop again to break the Diabolique loop there is two ways you can break it one is you don't want to have this risk of a sovereign default on the balance sheet of banks and that's there's no reason why Isis should be the case ideally this risk should be spread out across many many households if there's a risk of default it's fine Greece for example there's a was a default and click that it is very small relative to the European sized economy if everybody of you we're holding a little bit of Greek debt and then there were to be a default you wouldn't hardly notice it but because this debt is held by highly levered banks it's amplified and then a small shock is translated a much much bigger shock and much huge real amplification and the real economy and that's you have to minimize that think about this how it's done in the u.s. think about the municipal bond market in the US there's a lot of states and municipalities townships who issue a lot of pawns in the United States these bonds are not held by the banks to help individual households in the pension funds and so forth if one municipality or one state goes under defaults on it it doesn't amplify because it's not held is highly levered banks so you have to push essentially the risk of sovereign default out of this out of the balance sheet of the banks and in one way this espy's proposal that's one reason why we propose that because it's a senior bond is very safe the junior bond is risky the junior bond should be held by individual households you get a much higher return it's more risky but it has to be spread widely across many many households and should not be held by highly levered institutions highly levered institutions which then get a government guarantee and also are recapitalized to monetary policy there should hold some saved by arms they should not hold enter should lend to the real economy but they should not assume us of them that risk so how do you solve it either you have recapitalize the bank's much more right now the system is very inconsistent if you hold some risk is open tap you get a zero risk weight on the one hand with read sovereign debt as risk-free on the other hand we have the no bailout clause saying okay essentially we have to let some sort of ends default it's very inconsistent okay so either you have to go in one way or the other way but if you go all the way you want some defaults like the u.s. system on municipalities then you have to make sure it snapped held highly levered by institutions concerning second market purchase programs by the ECB why doesn't these beat us buy up all the government debt then that's exactly where the game of chicken comes if something goes wrong the ECB is holding out or all the losses if certain debt levels are not sustainable somebody has to cut back the expenditure or has to reform the economy to stimulate growth and if this doesn't happen only the fiscal authorities can do that monetary policy can just buy time and can make sure the framework is given that everything is fine but the fiscal authorities have to say okay we have to restructure the economy we have to change the laws we have to do that and if the physical story refuses this and just wants to issue know more and more debt and then DCP is buying it the knees P ends up with all the losses down the road and these bears no choice then to let the high inflation rule euro land and that's essentially the telomere distance that's why again with the OMT measures it imposes a conditionality circuit we only buy it once you join and become a program country and once you sign up for all these fiscal measures which should ensure down the road this fiscal debt level is sustainable yeah it was sort of an ultra cuestiones on Italy we were talking about fiscal consolidation efforts well our country made a major effort in 2011 governor was visco just recall this a very harsh action was taken 3 mmm 4 points of our GDP so much so that our country closed the year with deficit at 12% and as a matter of fact it a is not in a procedure for negative behavior so what do you think about the sustainability of Italian public finance in the medium term and do you think that there are there's any room there's any flexibility that Italy can use with the European Commission especially when it comes to public investments do you think there's room for maneuver there do you think that by means of the co-financing procedure Italy can start some kind of mini golden rule let's see whether there are more questions and I believe that we take just one more question which I don't have the scientists questioner says the chair there's room for one more question if I well first of all I'd like to thank professor Bolivia for this very rich lecture secondly I have a couple of questions one has to do with the European bonds I won't be ESB is a sim actually very interesting proposals can you expand a bit on the way they work the as yes B's I know whether I have the more time well we have ten minutes all together so we have to give back the floor to profess up on the Meyer because tiny time is nearly up so can you expand in a bit a bit on how they operate how these AE European safe bonds should operate what kind of bonds would they have to do with where they're going to be no issue with the B on the secondary market and would that do away with any problem of moral hazard event is indeed the main reason why those are that why many people criticize Euro bonds then I'd like to refer to common fiscal policy what do you think about having one single fiscal policy do you think there's a strong will politically to follow the example of the US with some kind of a fiscal federalism as American economists had proposed some ten years ago or do you think that we shall remain in a very fragile situation some very characterized by fragmentation thank you very much actually we would need another additional lecture to take all of your questions this is going to be the very last question professor Maya what do you think about the European legislation in which is elusive reaction to the problem that you refer to as for example crisis management bars Basel three with a single Banking Supervision how do you think that the reaction from the European Union was this is really going to be the best during these days I heard the different people's stated that the christ' originated from an excess in leveraged or indictment of too high debt so my question would be as follows what would be the break-even point we should aim at to be in the stability do we have to cut on debt because as a matter of fact of what you have apparently asked for is increasing that obviously we have disparities or differences in different countries and there's a balance between public and private that is different to different countries but I believe that again apparently in the finance has grown enormously and perhaps we should curb this abnormal abnormal growth of the finance I think that we should try and generate more wealth rather than more debts asked question so how much depth is sustainable that depends very much what the growth prospects of a country are and what potential demographics and many things playing I totally agree with you that we should actually aim for a lower level edge ratio and we might be able to do it with a smarter design you would like to have more equity issues rather than debt issues you might have would like to have debt which is indexed on the growth of a country so whenever there's a negative surprise shock it is absorbed and distributed wisely the risk is distributed widely in across many blares or many savers and they call me again the problem comes from leverage because leverage leads the concentration of risk too few players in the economy and then it amplifies the whole thing so if you can design them bonds which are indexed to GDP growth or some other things which are more equity like and less debt structures or instruments I think you can spread the risk more easily and you avoid the amplification and the negative impacts on the real economy so let me come back to the Italian question is so there are two components to it so should you cut back on expenditures right away so I think it's very important to have some structural reforms so now I'm not a guy who says okay you have to cut back your expenditures here and there just satisfy certain ratio I think what you would like to do is to change the structure makes the economy more efficient change your labor laws or any other laws you have make it easier for people to start a company in orders and it might be that down the road but not right now in the recession you cut back on the expenditures and you might raise some new tax revenue there so there might be a nice transition path where I say you have to commit the problem is for governments that they can always say you know in three years we will increase our taxes once we out of the crisis but then they changed the mind I can't really believe we're credibly commit to sort of strategy and that's a big problem but if there is a way to commit to this I think that's the way to go on now is there a what happens is of course there's also of the multiple equilibriums in this in area what I mean by that if the market believes that Italy will do well will reduce its debt will actually have a low expenditure ratio on GDP growth will come back they will lend to you at a lower rate and because the lent to you at a lower rate you can also find the transition and finding a way to get there okay if the mark so that's one equilibrium that's a one it's one coherence in the area where the whole thing might end up we might end up with and that's a good scenario of course there's another scenario which is also very consistent the market doesn't believe that the government down the road will do the right measures or will not restructure the right way to make the economy more efficient give the young people more challenges so there's an intergenerational a big problem in Italy that gives the young people more chances to find jobs build up human capital and be productive down the road and if the market believes this will not happen and down the road the GDP growth is not coming and expenditures will not be cut down the road where taxes revenue will be high enough but then they will charge a high interest rate because they our lending is more risky because the charge such a high interest rate the government will not be able to implement these reforms that's the other that's a bad scenario so the aim is essentially to credibly communicate to the marketplace that these measures are coming and that needs to be a certain trust between the market participants and the governments to generate and stay in this good scenario in the good equilibrium how will the espy's work let me move to the second question yet I could talk mean we have you know a long document on this how the details work so what we have in mind is that the espys is essentially a structure where there's no common and joint liability structure it's essentially there will be a European debt agency Europe and that agency is buying part of their soup and that lets make in case of Italy Italy is issuing some debt it has about 120 years 130 percent of GDP and in that level and this Europe at that agency would buy up 60% of GDP roughly half of the new ition so whenever Italy issues a new debt half of it is bought up by the Zupan debt agency the other half is still free-floating in the market hence there is a market price at this market price European debt agency is also buying up the Italian that ok of course there is some demand pressure coming from New York and debt HTT because it assumes half of the half of the tab this controls the moral hazard aspect if nightly should Italian government should do something crazy which is not sustainable down the road for the other half you have to pay your high intercept because the market positions will be scared and will charge a high interest rate and this European debt agency will also only buy it as high interest rate okay so the moral hazard aspects is under control through the interest rate and there many issues in terms you have also have to decide you know what maturity to issue if Italy's issuing certain depth is it a three or five-year ten-year bond of course and the espys has to be accordingly also three or five year tenure and the national debt agencies have to issue at the same time in order to have this coordinate it and board up by the European debt agency and then issued with the same maturity and all these things we can talk about this but there are many details which we have to worked out what about common in the fiscal policy I don't think I think all what we need is a common fiscal responsibility framework where people behave responsibly and find a way that the whole we don't end up with currently in a crisis so in a certain crisis situation now there's surely a willingness to get out of it but one one has to find a framework that we don't end up the crisis over and over again that that's the key and we have to find the right set up where this is will not occur over and over again so essentially there are two ways to control that one is through market discipline and one is through institutional arrangement so there will be some European Authority which says okay that's how much debt you can make it has to be sustainable that's what the physical compact is for that's one pillar the other pillar is essentially market discipline that's okay if you don't behave the interest rate is going up and we need a market discipline if you introduce a euro bond the market discipline is not there anymore and that's the question that's where the divide is so people say we don't need we don't need the market discipline other people say markets yeah we don't need it because you know it's not reliable anyway you've seen it so you know in crisis time suddenly the interest rate shoots up as I say no no we need the market discipline at the end of the day it's only the market discipline which really works these politicians that can agree to anything and at the end you know it doesn't bite because they get out of it Germany and France essentially when his depleting rose backed was biting them they just agreed to get out of it so politicians always find a way around it so the institutional arrangement is not really working either I think probably you need both and you have to be aware that both pillars might fail as the did last time around but just giving up one pillar and just relying on the other one alone I think is probably too risky and again we have to have some common rules within the fiscal units we can call it sharing of sovereignty is just make sure that you know we don't end up in a crisis in area over and over again finally European legislation concerning parcel 3c single super authority I think it's important right now it is the case that National Bank supervision was very much done at the national level and there was no information sharing across national supervisor very limited information sharing across supervisor so if the bank is in trouble in some country other supervisors would have no ideas about it and meticulous ECB would have no ideas and at the end these bees as you know help out we are actually a solvent bank and these if he doesn't know what's going on I mean it's this Bank solvent is an absorbent what assets on the books or what you know this impaired assets assets which are not worth much any more toxic assets and they have no idea what's going on so now with the super single supervisory structure these be has the power the goal into the books of these banks and figure out which banks are zombie banks and which banks alive reliable banks and should get funding at the end the role of a central bank is to provide liquidity support to solvent banks it is not at all of a central bank to help out insolvent banks and just mix all the banks out of them and it is the case and in certain countries the banking structure is just overblown there was huge housing booms in certain countries the banking sector is too big and the banking sector has to shrink it has to shrink the United States too and that's the reality there's no way around that if one sect is too big it has to come back to a regular size and that's essentially through the single supervisory framework you can achieve that what's also needed is a restructuring mechanism so you don't want that you know the bank has to really go into bankruptcy all the way down the road cause a lot of spill overs and then destroy large fractions of the economy what you really want is that you can actually close down the bank just before it is insolvent like this world prompt corrective action which like in the u.s. what's going on is that if a bank is very close to insolvency it will be closed on Friday afternoon on Monday morning it is opened under a different name and a different management and potentially merged with some other Bank and the shell is a wiped out and potential bondholders are wiped out too we have to find a really good framework which is the same across Europe we authorities can move in and close down these banks and reopen it on Monday such that the demand deposits that don't serve anything of course somebody has to be other losses the shareholders and some senior bond holders you have to pay our losses but we need some resolution Authority which can do that not believe it thank you very much professor premyer thank you very much to all of you who this most interesting Q&A time I learned quite a lot thank you very much I really learnt a lot I hope I can meet you again here in Trenton next year and it would be nice to talk not just about the effect of austerity or about how to tackle existing as a systemic crisis but in the case Europe starts on the right path supporting growth the supporting employment it would be nice to talk about that as it could happen after the summit next June so I hope to meet you again next year thank you very much to you all