Breaking the Sovereign Banking Feed Back Loop Public Hearing Success and Failures in Crisis Countries Committee on Economic and Monetary Affairs European Parliament Brussels, November 5, 2013 Fernando Fernández

What is wrong with Europe?: an alternative narrative Understanding the euro project Why is Banking Union so important? A brief note on Spain Europe: the solution to a self inflicted problem 2 © Fernando Fernández 2013

Macro imbalances around the world 3 © Fernando Fernández 2013 Source: Barclays, European Economics Quarterly, July 2013

The Euro unsustainability as seen from the outside 4 © Fernando Fernández 2013 Source: Institute of International Finance, Eurobrief, March IMF EuroArea Consultation, July 2013

Aggravated by Financial Fragmentation 5 © Fernando Fernández 2013 Source: IMF, WEO, October 2013

Interest Rates in the Euro Area 6 © Fernando Fernández 2013 Source: IMF, Global Financial Stability Report, October 2013

And the vicious circle of bank-sovereign-corporate deterioration 7 © Fernando Fernández 2013 Source: IMF, Global Financial Stability Report, October 2013

The Maastricht Treaty: a strange animal by design Independent monetary policy by the ECB ECB response is not really that different, but the environment is No safe European asset for monetary policy No lender of last resort facility until OMT was improvised No fiscal policy coordination National regulation and supervision of financial systems No European approach to banking regulation, supervision and resolution until late 2013 and still in the works National regulators, facing a textbook collective action problem, acted to aggravate the Euro crisis National fiscal policies subject to non-binding rules The Stability and Growth Pact unenforceable ex-post No bail-out, why can California default but Greece could not? No exit works both ways © Fernando Fernández,

The crisis showed the Euro was naked The Greek fiscal problem and what it reveals of EMU Open fiscal contingencies No stabilization fund Ireland and its banking problem No national lender of last resort Banking problems become sovereign problems Reflation is not possible, so default the only alternative No growth, loss of competitiveness in Portugal The “Argentina syndrome” How to ensure/impose structural reform? Internal devaluations are painful and take time Cyprus : Sequencing issues: Bail in before Resolution Authority and Common Deposit Guarantee Capital controls cannot be part of the tool kit © Fernando Fernández,

The Cost of the Banking Crisis 10 © Fernando Fernández 2013 Source: IMF, Fiscal Monitor, October 2013

 Monetary Union as envisaged in Maastricht is dead  For good reasons. It was never an optimum currency area  But it is taking a long and painful time to go  Normative Economics: what should happen Banking Union Fiscal Union Political Union: No taxation without representation And even so, everything is possible, because growth is of essence in a democratic Union  Positive Economics: what is likely to happen Muddle through, playing at the edge Uncertainty, volatility, sudden events and prolonged subdued growth  But an accident may always happen Despite today being highly unlikely Understanding Europe: Likely scenarios © Fernando Fernández,

Banking Union © Fernando Fernández,  A single supervisor. Basically agreed but Will markets wait for late 2014? Too much national discretion AQR, Balance sheet assessment and Stress testing dangerous without a common fiscal back stop  A Common Resolution Authority A 3 stage approach: prevention, restructuring and liquidation Will the pecking order of losses be applied uniformly? It entails, by definition, mutualization of the debt. (quasi-fiscal) It cannot be the Commission: No country allows Bank recapitalization to be decided by the Competition Authority An European Deposit Guarantee Fund is missing  To break the vicious cycle of banking ad sovereign crisis  To allow fair competition to the benefit of the consumer  To avoid extensions of “bank holidays”  Three decisions: coverage, funding and institutional

A Limited Fiscal Union 13 © Fernando Fernández, 2013 – A Fiscal Union does not mean full tax or expenditure harmonization but simply avoiding externalities – Euro Treasure Common monetary policy requires an euro risk free asset An asset that has to meet strict requirements: (i) depth and liquidity (ii) ample references at all maturities; (iii) actively traded in liquid markets; (iv) available in the short run for existing debt and not only for future debt, the legacy problem; and (v) its emission to be the sole responsibility of the Euro Treasure An Euro Treasure issuing an euro asset leads to decide on: – (i) the source of funds: Euro Tax (new or old) vs. revenue sharing mechanisms – (ii) the use of funds: the European Stabilization Fund – Fiscal rules for the Euro Zone, Rationale: To avoid national policies impeding adequate functioning of common monetary policy Implication: A binding restriction on national budgetary aggregates Evolution: Complex structural rules increasing implementation risk

A note on Spain  The case of Spain is an euro crisis It could not have happened without the euro It will not be solved without addressing the mistakes in Maastricht  Spain adjustment is work in progress. A proven willingness to reform, however reluctantly A significant turn around in banks solvency and profitability, fiscal consolidation and external competitiveness. Foreign Investment, both debt and equity flows, coming in Institutional stability But employment growth remain and will remain elusive.  Challenges and priorities for the future Restore and maintain fiscal balances in a highly decentralized state Job creation and additional labor market and education reform And creating a more business friendly environment © Fernando Fernández,