Fiscal, economic and financial vulnerabilities: implications for Euro area surveillance

Abstract

Sound public finances are necessary for the functioning and economic prosperity of a common currency union. The financial, economic and European sovereign debt crises revealed that financial stability and economic growth also serve as prerequisites and that all three interact in this respect. This has made clear that containing related vulnerabilities and risks in order to effectively prevent serious crises is complex and not sufficiently addressed by the current institutional framework of the Euro area. Substantial institutional shortcomings are now being addressed by reforms. However, in this article, we argue that further institutional reforms are needed in order to integrate vulnerability and risk analyses into surveillance processes. Above all, we propose setting up an independent expert council that is charged with the evaluation of all surveillance processes.

Keywords:

• Euro area
• institutions
• macro-prudential surveillance
• fiscal policy

JEL Classification:

• E62
• F36
• F55
• H77
• H87

Acknowledgements

The authors thank the participants of the BdF conference and in particular António Afonso, Rüdiger von Kleist and William Brunton for fruitful comments on the subject. The opinions expressed in this article are the authors’ personal ones and do not necessarily reflect the positions of the German Federal Ministry of Finance.

Notes

¹ We use the term ‘vulnerability’ to describe a characteristic shortcoming of an institution, actor or situation that may be inherent or self-made. A bank having a disproportional amount of sovereign bonds of country X is vulnerable to X’s financial situation. However, as long as this country runs sustainable public finances, the bank’s liquidity and solvency risks would still be low. Hence, as the IMF summarizes, a vulnerability is a ‘necessary, but not a sufficient, condition for a crisis’ (IMF, 2010, p. 8). A risk then describes the extent to which a vulnerability may materialize under specific conditions, as e.g. X’s public finances sustainability decreases (cf. ECB, 2010, p. 139).

² As the ECB, we use the term ‘financial stability’ to describe a ‘condition in which the financial system – which comprises financial intermediaries, markets and market infrastructures – is capable of withstanding shocks and the unravelling of financial imbalances’ (ECB, 2012, p. 5).

³ These criteria vary depending on the type of crisis that is at the centre of the analysis. For example, in order to identify a fiscal crisis in advanced economies, Baldacci et al. (2011b) take into account four criteria: a high yearly inflation rate, the occurrence of public debt default or restructuring, the realization of a large-scale IMF-supported programme and a large deviation of sovereign bond yield spreads.

⁴ Two ways to identify these thresholds are used in the literature: one is to minimize total misclassified errors, i.e. the weighted sum of false positive crisis signals (type I errors) and false negative crisis signals (type II errors). Another is to maximize the signal-to-noise ratio, i.e. the ratio of the percentage of true positive signals (1 – type II errors) to the percentage of false positive signals (type I errors) (cf. Baldacci et al., 2011b).

⁵ Cottarelli’s (2011) approach has also been used in the IMF Fiscal Monitors as of 2011; due to data limitations, however, this approach has so far only been applied to country groups, not individual countries.

⁶ The IMF plans to extend this ‘toolkit’ to include the investor basis, the currency in which debt is denominated and contingent liabilities.

⁷ For a detailed description of the univariate signalling approach to identify fiscal sustainability risks, refer to Baldacci et al. (2011b). Compared to earlier works, Baldacci et al. (2011a) use the broader definition of fiscal crises introduced by Cottarelli (2011).

⁸ Overall, four approaches are presented in the 2011 report on public finances in EMU. Only two will be discussed in this article as they are already used or planned to be used by the EC for vulnerability assessment.

⁹ Details on the methodology are laid out in De Lisa et al. (2010).

¹⁰ The regulatory framework scenarios vary with respect to the underlying capital requirements, with respect to whether deposit guarantee schemes and bank resolution funds are in place to absorb banking losses, whether a bail-in rule of bondholders and noncovered depositors exists, and whether contagion effects are taken into account (cf. EC, 2011).

¹¹ The S2-Indicator expresses the ‘permanent adjustment in the primary balance necessary to meet the intertemporal budget constraint over an infinite horizon’ (EC, 2009, p. 34).

¹² Some minor differences exist as Baldacci et al. (2011b) set different thresholds for emerging and for developed economies with regard to the inflation rate, while the EC (2009) approach only considers developed economies.

¹³ The Euro-Plus-Pact and the Europe 2020 Strategy will not be considered here although one might also make use of these less institutionalized processes to improve surveillance of vulnerabilities and risks. Moreover, we do not consider micro-prudential supervisory agencies and the FSB as it is not part of the Euro area level institutional setting. Also, we do not consider financial support programme agencies as they are clearly supposed to be temporary. For an overview and general assessment of the recent reform packages, cf. Kastrop and Ebert (2009, 2012).

¹⁴ ‘Six-Pack’: Regulation (EU) No 1173/2011; Regulation (EU) No 1174/2011; Regulation (EU) No 1175/2011; Regulation (EU) No 1176/2011; Council Regulation (EU) No 1177/2011; Council Directive 2011/85/EU; ‘Fiscal Compact’: Treaty on Stability, Coordination and Governance; ‘European Semester’: ECOFIN-Council Press Release 13161/10, 07/09/2010, For a detailed assessment cf. Kastrop and Ebert (2012).

¹⁵ Not all new elements of that process can be reviewed here; we focus on the elements capturing risks and vulnerability.

¹⁶ The scoreboard and in particular the issue of current account surplus had been discussed intensely among politicians.