Introduction

The central role of the European Court of Justice in the process of ‘constitutionalizing’ EU law, whereby the Court has deemed certain provisions of EU law to be an integral and directly enforceable part of the law of the Member States, has long generated animated debate amongst EU law scholars. One part of this story which has not always attracted the same degree of attention is the way in which the Court of Justice extended aspects of its constitutionalization strategy to international legal norms. The relative paucity of EU Treaty provisions governing the status and effect of international law in the new European Communities at the time left considerable room for the Court to shape the answer to these questions. In some of its early case-law, the ECJ (European Court of Justice) adopted what has been called an ‘automatic incorporation’ approach to international agreements, deeming them to be part of the EU legal order and their provisions to be enforceable in domestic and EU courts at the suit of individuals. In this way one of the most important sources of international law – international treaties – were from a relatively early stage treated by the Court as a presumptively integral part of the new European legal order. Even if the dimension of this case-law which generated the most extensive commentary was that which subsequently departed from the basic automatic-incorporation approach, namely the Court’s decision to rule out the direct judicial enforceability of the GATT (General Agreement on Tariffs and Trade) and WTO (World Trade Organization) agreements, the general approach of the ECJ to international treaties was to treat them as fully part of the EU legal order and judicially enforceable at the suit of litigants. Further, this embrace of treaties as a central part of the EU legal order was accompanied by what seemed to be a fairly open approach to customary international law as part of EU law. By developing and using a range of doctrinal devices such as the principle of consistent interpretation and the treatment of international legal principles as part of the general principles of EU law, the ECJ exhibited an attitude of notable openness towards international law. In all, its approach to international legal obligations appeared to be one of engagement and loyalty, with the Court positioned as an agent to ensure compliance on the part of the EU and its Member States with the EU’s international obligations. This picture of the ECJ as a faithful enforcer of international legal obligations meshed well with the more general self-image promoted by the EU of an organization devoted to the international rule of law, whose international profile was defined in significant part by this distinctive commitment to international law and institutions.

Introduction

Ireland is in the midst of a severe crisis. While the global financial crisis has affected all economies to varying degrees, it has been especially severe in Ireland with a cumulative nominal GDP decline of 21 per cent from 2007Q4 to 2010Q3. This ranks Ireland among the worst-affected countries in terms of output performance during this period (Lane and Milesi-Ferretti, 2011).

Allied to this economic shock, Ireland has also experienced a severe fiscal deterioration. After a long period of running surpluses, the fiscal balance shifted from positive territory in 2007 to baseline deficits of 11–12 per cent of GDP in 2009 and 2010. Much of this fiscal deficit is structural in nature, such that the resumption of economic growth on its own is not sufficient to restore fiscal sustainability. In addition, the one-off cost of recapitalising the banking system pushed the overall general government deficit to 14.5 per cent of GDP in 2009 and 32 per cent of GDP in 2010, leading to rapid growth in the overall level of public debt.

As crises often do, the global financial crisis we have been experiencing has highlighted key policy challenges that were insufficiently attended to in the past and has focused minds on needed improvements. In Europe, the crisis has exposed fault lines in governance and deficiencies in the architecture of the financial supervisory and regulatory framework. The need for more effective micro- and macro-prudential regulation and supervision, but also for better coordination between the two as well as among regulators, has been underlined. The crisis has confirmed that central banks can play an important role in safeguarding financial stability, but also demonstrated that a mandate to maintain price stability is not sufficient to ensure financial stability, strengthening the case that central banks need to be armed with the appropriate policy tools to enhance their contribution to financial stability.

The crisis has prompted critical thinking about the EU economic and financial policy frameworks and the need for a new supervisory architecture. The severe economic cost suffered as a result of the crisis, and the acknowledgement of the need to limit the likelihood of future costly occurrences, has provided an important opportunity for the development of an improved financial stability framework for Europe and highlighted the urgency of the need for a comprehensive crisis management regime. Not that this was not understood earlier. The lack of harmonisation in the European legal and supervisory framework and its potential cost in managing crises were known. Nevertheless, perhaps due to the complications and political sensitivities involved in addressing crisis management, and perhaps owing to other policy priorities, undue reliance was arguably given to the role of crisis prevention, avoiding prickly issues such as how potential losses associated with the efficient resolution of a cross-border financial institution were allocated.

Introduction

There is widespread recognition among academics and policy-makers that monetary policy should aim at price stability. A large number of economies have adopted inflation targeting (IT) as the main objective of monetary policy, aiming at maintaining low and predictable inflation rates as a way of preserving the purchasing power of money. Evidence abounds that targeting inflation has been successful in anchoring and stabilising inflation rates and inflation expectations, with no apparent increase in output volatility, from the end of the 1980s to the beginning of this century (Mishkin and Schmidt-Hebbel, 2001, 2007). Moreover, there is mounting evidence that inflation targeting contributes to keeping inflation low and predictable (Fatás, Mihov and Rose, 2006; Angeris and Arestis, 2008; Benati, 2008; Calderón and Schmidt-Hebbel, 2008).

Nonetheless, current monetary policy frameworks have been brought into question by the frequency with which deflation has taken hold of or threatened OECD economies. Japan went through a period of deflation in 2000–6 while the US was perceived to be exposed to a deflation risk in 2001 and again in 2003. A consequence of the current financial and economic crisis is that deflation has once more emerged as a risk, this time in many OECD countries, while it has taken hold of Japan again. While monetary policy frameworks may need to be reassessed with a view to reducing deflation risk, any changes should occur only once current objectives are attained, for fear of undermining confidence in central banks. Against this background an alternative interpretation of price stability has attracted increasing attention from policy-makers in the recent past (Ambler, 2009; Parkin, 2009): it is the notion of price-level stability, where the monetary authority aims at stabilising an aggregate price level around a pre-specified path, instead of its rate of change. A principal advantage of price-level targeting is that it is more consistent with the objective of preserving the long-run purchasing power of money. For instance, following a temporary inflation spike, such as that observed in 2005–7, inflation targeting regimes will leave the purchasing power of money permanently below what would have transpired if inflation targets had been met. A successful price-level-based framework would also avoid a permanent increase in the real value of debt after a period of deflation. Practical experience of price-level targeting is, however, restricted to one historical episode, in Sweden during the 1930s (discussed on p. 312).

Introduction

The recent global financial tsunami has had economic consequences that have not been witnessed since the Great Depression. But while some countries suffered a particularly large contraction in economic activity on top of a system-wide banking and currency collapse, others came off relatively lightly. This chapter aims to explain this difference in cross-country experience by means of a non-structural econometric analysis using a variety of potential pre-crisis explanatory variables in a cross-section of forty-six medium-to-high-income countries. The severity of the macroeconomic impact is measured in terms of the depth and duration of the contraction in both output and consumption. Potential pre-crisis explanatory variables are chosen to reflect propagation channels for the global crisis typically mentioned in the literature, i.e. a financial channel, a trade channel, a macro channel and an institutional channel, although we offer some new variables that have not been included in such analyses before as far as we know. As another contribution to the analysis of the current crisis, we also use cross-country ordered probit regressions to identify the main determinants of the probability of domestic systemic banking or currency crises during the current crisis period.

Our results suggest that the macro channel played a prominent role, as domestic macroeconomic imbalances and vulnerabilities are found to be crucial in determining the incidence and severity of the crisis. An especially important pre-crisis macroeconomic indicator, which seems to capture factors that are important in explaining the extent of the crisis along many different dimensions, is the rate of inflation in the run-up to the crisis. We also find evidence suggesting the importance of financial factors. In particular, we find that large banking systems tended to be associated with a deeper and more protracted consumption contraction and a higher risk of a systemic banking or currency crisis. Our results suggest that greater exchange rate flexibility coincided with a smaller and shorter contraction, but at the same time increased the risk of a banking and currency crisis. We also find that countries with exchange rate pegs outside the European Monetary Union (EMU) were hit particularly hard, while inflation targeting seemed to mitigate the crisis. Finally, we find some evidence suggesting a role for international real linkages and institutional factors.

Introduction

The impact of the crisis on the Spanish economy, although qualitatively similar to that in other countries, shows some important quantitative differences. First, the cumulative decline in GDP (−4.5 per cent) has not been as large. Secondly, the banking sector started the crisis with more solid portfolios, as Spanish banks were kept away from the ‘toxic assets’ that initiated the first phase of the crisis, and has not imposed too much stress on public finances. Thirdly, despite the mild decrease in GDP, cumulative employment losses (−9.4 per cent) and the increase of unemployment (almost 12 percentage points) have been extremely high, due to some peculiarities of the Spanish labour market. Finally, after a decade of fiscal consolidation in which there was a long period of running fiscal surpluses and the debt-to-GDP ratio was brought below 40 per cent, there has been a severe deterioration in the fiscal position, with a deficit of 11.1 per cent in 2009. Despite the low debt-to-GDP ratio and the government commitment to restore fiscal soundness by 2013, Spain was temporarily among the ‘collateral victims’ of the Greek debt crisis. While the problems of the banking system seem currently under control, Spain faces the policy dilemma of restoring competitiveness and growth within a monetary union -- that is, without control of the exchange rate and interest rates -- at the same time as running down the volume of private debt accumulated before the crisis and that of public debt which increased sharply in response to the effects of the crisis.

Understanding this sequence of events and the policy options to restore growth requires revisiting the driving factors of the long expansion during the pre-crisis period and the impact of alternative policies. The pre-crisis expansionary phase was mostly driven by two factors: (1) a significant expansion of credit, which was induced by the fall in interest rates that followed Spain's entry into the European Monetary Union (EMU) and, more broadly, by a pervasive relaxation in the conditions of access to credit, and (2) the large immigration inflows into Spain over the period that substantially modified the demographic structure of the Spanish population.

Introduction

Better resolution forms a key component of the cure against future crises – along with better regulation, better supervision and better macroeconomic policy (Huertas, 2010a). This chapter outlines a possible path toward better resolution for large, systemically important financial firms.

Achieving better resolution of such firms is essential. ‘Too big to fail’ is too costly to continue, and ways must be found to assure that failing banks can be resolved at no cost to the taxpayer and limited cost to society at large. ‘Too big to fail’ distorts competition, creates moral hazard and threatens the public finances. The foundations for moving away from ‘too big to fail’ are being laid: they are the introduction of special resolution regimes for banks and the requirement that banks prepare ‘living wills’ (recovery and resolution plans). On top of these foundations now needs to be built a means of resolving large, complex cross-border banks without equity support from taxpayers. Bail-in offers the promise of such a solution, and this chapter analyses how that promise might be fulfilled.

How can we strengthen public confidence in the euro project following the Greek public debt crisis? To do so, it is crucial to remove the risk of a full-blown sovereign debt crisis, which could easily trigger a banking crisis, in the euro area. This requires us to resolve the conflict between national fiscal policy and supra-national monetary policy by reinforcing the institutions underpinning fiscal policy.

To my mind, three sets of measures need to be adopted: we need to strengthen the Stability and Growth Pact (SGP); we must ensure that fiscal policy is subject to stringent surveillance and supervision; and we have to make sure that there is a permanent and credible crisis resolution mechanism that provides incentives for investors not to lend, and for governments not to borrow, excessively.

The problems of the euro area brought to light some failures of the system. Nevertheless, the resulting drop in confidence in the system has gone further than one could expect. Questions have even arisen about the system's survival. Yet monetary systems do not tend to dissolve simply because of faulty performance. On the contrary, as a rule they endure even when they function very badly. It takes a political force majeure to bring about the break-up of a single currency area, typically without connection to its monetary performance. Why, then, has the possible default of a country engaged in irresponsible fiscal policy and accounting for only 3 per cent of the euro area's GDP raised questions about ‘saving the euro’ and the survival of the Eurozone? The issue has not received the attention it deserves. It is often simply taken for granted that the departures from the Stability and Growth Pact (SGP) provide a sufficient reason for the earthquake that has shaken the whole currency area. Yet if we look around the world past and present, the mismanagement of finances by regional governments has no particular tendency to bring down entire monetary systems, far from it. In line with the usual – I think superficial – diagnosis of the ailment, proposed remedies for the euro area centre on strengthening the SPG, increasing joint political control over fiscal policy and providing joint insurance against government default, or some mixture of the three. But what if a vital element of the problem is really the official doctrine that sovereign default is incompatible with the euro? What if the scale of the crisis that took place has resulted from financial markets’ conviction, based on that doctrine, that the future of the euro was at stake? What if assuring the long-run sustainability of the euro means convincing those markets, quite differently, that nothing as manageable as a Greek default can upset the euro area? That is precisely what the US example would suggest and what I will defend. In that case, the right road ahead looks quite different. It means shifting the emphasis away from avoiding government defaults toward assuring the stability and the solvency of the banking system at all times, regardless of the financial difficulties of some member governments.