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The Euro &The Battle of Ideas

Markus K. Brunnermeier,

Harold James & Jean-Pierre Landau

London School of Economics London, 20. October 2016

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Why ideas?

Interests - incentives

Institutions

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Ideas - ideologies• Interests are interpreted through the lens of ideas ≈models • Different economic philosophies

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Why France & Germany?

Power shifts

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Why France & Germany?

Power shifts• 2010, May: EFSF, IMF Intergovernmental - “Chefsache”

• 2010, Oct: Deauville PSI Paris Berlin

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Overview

Watershed moments• 2010, May: EFSF, IMF involvement

• 2010, Oct: Deauville PSI: contagion

• 2012: Draghi’s “Whatever it takes” Speech

• 2013: Cyprus Bail-in

• 2016: Brexit

Maastricht’s Ghost: Monetary and fiscal stability

Maastricht’s Stepchild: Financial stability

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Is difference caste in stone? … cultural?

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“German” Federalism

Holy Roman Empire

“French” Absolutism/Centralism

King Luis XIV, XV, XVI 1643-1715, 1715-1774, 1774-1792 A.D.

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… or fickle?

Historic breaks and reversals after World War II

“France” “Germany”

from laissez-faire from cameralism/state tradition

to planisme to Ordo-liberalism

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“French” “German”

1. Discretion Rules

2. Solidarity Liability• Fiscal union No-bailout clause

3. Liquidity Solvency

4. Keynesian Stimulus Austerity/Reform

Ghost of Maastricht “Rhine Divide”

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Ideal types (Max Weber) White-black comparison to sharpen contrast

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“French” “German”

1. Discretion Rules

Active management ▪ Autonomous - no “ad hocery”

Current crisis management ▪ Future crisis prevention

Ghost of Maastricht “Rhine Divide”

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“French” “German”

1. Discretion Rules

Active management ▪ Autonomous - no “ad hocery”

Current crisis management ▪ Future crisis prevention

Straitjacket commitment Safety/escape valves

Commit future to fix current crisis

Ghost of Maastricht “Rhine Divide”

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“French” “German”

1. Discretion Rules

Active management ▪ Autonomous - no “ad hocery”

Current crisis management ▪ Future crisis prevention

Straitjacket commitment Safety/escape valves

Commit future to fix current crisis

• Commit not to default some debt restructuringin order to keep current (not official debt)interest rate low

Ghost of Maastricht “Rhine Divide”

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“French” “German”

1. Discretion Rules

Active management ▪ Autonomous - no “ad hocery”

Current crisis management ▪ Future crisis prevention

Straitjacket commitment Safety/escape valves

Commit future to fix current crisis

• Commit not to default some debt restructuringin order to keep current (not official debt)interest rate low

• Commit to currency peg/not to exit currency unionin order to discourage currency attacks

Ghost of Maastricht “Rhine Divide”

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“French” “German”

1. Discretion Rules

Active management ▪ Autonomous - no “ad hocery”

Current crisis management ▪ Future crisis prevention

Straitjacket commitment Safety/escape valves

Commit future to fix current crisis

• Commit not to default some debt restructuringin order to keep current (not official debt)interest rate low

• Commit to currency peg/not to exit currency unionin order to discourage currency attacks

Manage capital flows!

Ghost of Maastricht “Rhine Divide”

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“French” “German”

1. Discretion Rules

Active management ▪ Autonomous - no “ad hocery”

Current crisis management ▪ Future crisis prevention

Straitjacket commitment Safety/escape valves

Commit future to fix current crisis

• Commit not to default some debt restructuringin order to keep current (not official debt)interest rate low

• Commit to currency peg/ floating exchange ratenot to exit currency unionin order to discourage currency attacks

Manage capital flows! Free capital flow

Ghost of Maastricht “Rhine Divide”

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“French” “German”

1. Discretion Rules

Active management ▪ Autonomous - no “ad hocery”

Current crisis management ▪ Future crisis prevention

Straitjacket commitment Safety/escape valves

Commit future to fix current crisis

• Commit not to default some debt restructuringin order to keep current (not official debt)interest rate low

• Commit to currency peg/not to exit currency unionin order to discourage currency attacks

Ghost of Maastricht “Rhine Divide”

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Free capital flow

Fixed ex-change rate

AutonomousMonetary Policy

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Ghost of Maastricht “Rhine Divide”

“French” “German”

1. Discretion RulesStraitjacket Commitment Safety/escape valves

Active management ▪ Autonomous - no “ad hocery”

1. Time inconsistency 1. Unforeseen contingencies(not ex-ante efficient)

2. Politics/Lobbying

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Problems

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Ghost of Maastricht “Rhine Divide”

“French” “German”

1. Discretion Rules

Institutional Design (mechanism design)

• Fiscal dominance

• Monetary dominance

• “Financial dominance” Be strategically weak!

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Fiscal authority

Central Banksplit

Fiscal authority

Central Bank

Game of chicken

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Ghost of Maastricht “Rhine Divide”

“French” “German”

1. Discretion Rules

2. Solidarity Liability• Fiscal union No-bailout clause/rule

• Illusion of default free bonds SDRM/insolvency procedure

• Eurobonds with joint liability Avoid any joint liability (ESBies)(sovereign debt is anyway default free)

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Ghost of Maastricht “Rhine Divide”

“French” “German”

1. Discretion Rules

2. Solidarity Liability

3. Liquidity Solvency • multiple equilibria E[NPV]>0, at what discount rate?

“big bazooka” “throw good money after bad”

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Ghost of Maastricht “Rhine Divide”

“French” “German”

1. Discretion Rules

2. Solidarity Liability

3. Liquidity Solvency • multiple equilibria E[NPV]>0, at what discount rate?

“big bazooka” “throw good money after bad”

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Ghost of Maastricht “Rhine Divide”

“French” “German”

1. Discretion Rules

2. Solidarity Liability

3. Liquidity Solvency • multiple equilibria E[NPV]>0, at what discount rate?

“big bazooka” “throw good money after bad”

• amplification/spirals E[NPV bailout]>0

E[PV bailout – PV no bailout]>0

contagion/systemicBail-out/LLR Bail-in

Countries ▪ Fire-walls

Financial Sector

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“French” “German”

1. Discretion Rules

2. Solidarity Liability

3. Liquidity Solvency

4. Keynesian Stimulus Austerity/ReformDemand Supply • Output gap unsustainable credit boom

• Reforms in boom Reforms in crisis (political economy)

Ghost of Maastricht “Rhine Divide”

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Overview

Powershift

Maastricht’s Ghost: Monetary and fiscal stability

Maastricht’s Stepchild: Financial stability

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Maastricht’s Stepchild: Financial Stability

Why was financial sector ignored in early 1990s?• Large growth EU banks became global banks

• Whole-sale funding cross-border funding

Liquidity Spirals, Fire Sales, Spillovers, Systemic Risk• Southeast Asia crisis only occurred in 1997/8

Disinflationary Spiral • Japan experience was not absorbed

Deflation if banks don’t lend to productive firms (only to zombies)

Money multiplier collapses

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Contagion, Spillovers, Systemic Risk

“French” “German”

1. Liquidity & Contagion Solvency • multiple equilibria E[NPV]>0, at what discount rate?

“big bazooka”

• amplification/spirals E[NPV bailout]>0

E[PV bailout – PV no bailout]>0

contagion/systemic risk

Bail-out/LLR Bail-in Countries ▪ Fire-walls

Financial Sector

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Contagion, Spillovers, Systemic Risk

“French” “German”

1. Liquidity & Contagion Solvency • multiple equilibria E[NPV]>0, at what discount rate?

“big bazooka”

• amplification/spirals E[NPV bailout]>0

E[PV bailout – PV no bailout]>0

contagion/systemic risk

Bail-out/LLR Bail-in Countries ▪ Fire-walls

Financial Sector

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Two Diabolic (doom) loop

Government-banking nexus (deadly embrace)

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Gov. debt: safe versus contingent

“French view”• Almost never default

Straitjacket commitment

• No risk weights

• Banks as hostage Default would destroy

banks and economy

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“German view” • Default in tail events

“Safety valve”

• Risk weights on risky s-debt

• Banks as insurance providers

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Gov. debt: safe versus contingent

“French view”• Almost never default

Straitjacket commitment

• No risk weights

• Banks as hostage Default would destroy

banks and economy

• Lowers interest rate chance to get out of crisis,

• Doubling up strategy, but ..

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“German view” • Default in tail events

“Safety valve”

• Risk weights on risky s-debt

• Banks as insurance providers

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Two Challenges

Challenge 1: Safe asset + sovereign debt restructuring w/o diabolic loop

Challenge 2:No asymmetrically supplied safe asset• German Bund

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French IMF/Anglo-American/German

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Solution: ESBies

Across borders

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sovereign bonds ESBies

Junior Bond

A L

Across two European bonds

• Euronomics Group (2011) www.euro-nomics.com

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Conclusion

Ideas matter! – not only interest/incentives

Powershift in 2010• IMF, EFSF Intergovernmental• Deauville Paris-Berlin

“Rhine Divide”• Ghost of Maastricht Price and fiscal stability

Rules vs. Discretion, Solidarity vs. Solidity/Liability, Liquidity vs. Solvency, Stimulus vs. Reforms

• Stepchild of Maastricht Financial stability Liquidity spiral, contagion, diabolic (doom) loop, … Disinflationary spiral

Proposals• European Safe Bond (ESBies)• Fire-walls & “Race away from the bottom”, … 47