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.

Both Austria and Slovakia are located in the Central European region – they are part of the Central European family. As a matter of fact, Austria has made effective use of this location in the two decades since the fall of the Iron Curtain. It has become one of the most important investors in its Central European neighbours. Austria's economic links to Slovakia are especially strong, not least because of the short distance between the two capitals, Vienna and Bratislava. Today both countries are also members of the euro area, which strengthens their relationship even further.

The euro was a milestone of European integration (Nowotny, 2010). Against the background of the global financial crisis, it seems to be the right time to discuss and reflect on the euro's development from both a European perspective and from a global angle. In the early stages of its existence, the euro was under heavy criticism. The well-known argument of proponents of the optimum currency area (OCA) theory associates the costs of joining a monetary union with the loss of domestic monetary policy, the well-known argument that ‘one size cannot fit all’. Certainly, a currency union becomes costly if the business cycles of its member countries are not synchronised and if domestic adjustment capabilities are limited. In the absence of country-specific monetary policies, an idiosyncratic shock cannot be absorbed through the real exchange rate but has to be digested via flexible wages, fiscal transfers and mobile factors of production.

Introduction

When euro notes and coins were originally introduced in January 2002, consumers in the member states of the Eurozone experienced a sharp spike in perceived inflation, which translated into a permanent perception that the switch to the new currency was associated with a one-time inflation shock. As evidence of this, the synthetic indicator of perceived inflation over the previous twelve months compiled by the European Commission from consumer surveys showed a jump from 27 in December 2001 to 60 in September 2002 and remained above 50 for most of 2002. The most succinct summary of this view was coined in Germany, where the euro was promptly dubbed ‘teuro’ (from teuer, meaning ‘expensive’ in German).

For consumer prices as a whole, the perception was largely disproved by the actual data on the development of consumer prices during the relevant period. Prices in January 2002 rose by 0.09 per cent in the Eurozone according to the harmonised index of consumer prices (HICP) and the annual inflation rate during 2002 was also similar to 2001 and 2003, oscillating between 2 per cent and 3 per cent (although there was an unusual jump at the beginning of 2002, attributed mainly to the weather). Therefore, the explanations of discrepancies between the perceived and the actual inflation tended to focus on either purely psychological interpretations of how individuals could experience higher inflation at the time of a change in currencies without any basis in reality, or interpretations combining higher-than-normal changes in specific prices, which are likely to form anchors of consumer experiences, with psychologically based misconceptions.

Introduction

Since the early 1990s many European countries have introduced fiscal rules and procedures which are aimed at either preventing or reducing fiscal imbalances. This development reflects three main factors: the experience of the previous decades, characterised by large imbalances, public debt growth and the implementation of pro-cyclical policies; the creation of the Economic and Monetary Union (EMU) and the introduction of fiscal rules at the European Union (EU) level; and the challenges of ongoing demographic changes.

The reforms have involved three main lines of action: (1) the introduction of numerical fiscal rules; (2) the modification of budgetary procedures, in particular with a view to strengthening the role of the Ministry of Finance and to making budgetary policy more medium-term oriented; and (3) the creation of independent fiscal institutions, which can contribute to macro fiscal forecasting, fiscal analysis, policy design and even implementation.

In this chapter we argue that the attractiveness of the euro for CEE economies has always depended on (1) their willingness and capacity to invest in an independent stabilising monetary policy, and (2) the credibility of the euro project going forward. These are not new criteria, but it is worth recalling that the last decade has dispelled as unfounded the hopes that the euro is a convergence-bringing panacea or a substitute for structural reforms and fiscal discipline. Besides, the crisis and the unfolding fiscal consolidation programmes are reducing the attractiveness of the euro further in the short term. However, it is also worth recalling that the euro has been successful in bringing an important degree of monetary stability to the euro area, and has sheltered its members from many shocks. The attractiveness of the euro project for the Central and Eastern Europe (CEE) countries thus depends on the euro area's ability to build on these achievements. For the CEE countries that have been fixing their currencies, an early euro adoption should be a priority.

The economic debate about euro adoption should be cast in terms of the stabilising role of monetary policy – other considerations may be misleading. At the onset the euro was hoped to improve the long-term macroeconomic performance of member countries, not only in terms of price stability but also in terms of long-term output levels and growth rates. And the arguments portraying the euro as a vehicle of real convergence began to dominate in rationalising the common currency project.

Introduction

After several years of very strong economic growth, the Baltic countries have witnessed one of the deepest recessions in the world. In an historical context, the expected cumulative output loss associated with this Baltic recession is almost twice the size of the losses suffered by the hardest-hit countries in the 1997–8 Asian crisis, and in the case of Latvia comes close to the size of the US output decline during the Great Depression.

Despite many similarities in structural characteristics (including fixed exchange rate arrangements) and macroeconomic developments prior to the crisis, the Baltic countries have shown clear differences in their ability to cope with the common negative shocks associated with the global economic crisis. Estonia has been more successful than its Baltic neighbours in withstanding the impact of the financial crisis, and will join the euro area from 2011. Resilience to the crisis has been weakest in Latvia, which is dependent on financial support from the International Monetary Fund (IMF) and the EU and has a more uncertain economic outlook.

The euro area's future is troubled because of the heterogeneity of its members. Beneath the surface of satisfactory performance for the euro area as a whole, its first decade was characterised by divergence in key macroeconomic indicators among member countries (e.g. inflation rates, current account positions and real effective exchange rates). This divergence points to the source of the problem. It does not lie with the credibility of the European Central Bank (ECB). Rather, it lies with the difficulties for a number of countries in operating with a single currency. These arise from persistent differences in how labour markets work in member countries and in how different governments have approached the problem of stabilising the national economy within a common currency area (CCA).

The euro area's first decade shows that the choice of monetary regime can affect economic outcomes on the real side of the economy. Expectations that private and public sector agents would change their behaviour once a single currency was adopted proved overoptimistic. Contrary to the expectations of many observers, in the private sector, wage- and price-setters did not modify their behaviour in ways consistent with sustainable growth within a CCA. In the public sector, the need to stabilise national bouts of excess demand was neglected. The markets failed to signal the build-up of these tensions: until the sovereign debt crisis emerged in early 2010, and spreads on the bonds issued by euro area governments remained until then very narrow.