European Financial Crisis: Economic and Political ...

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European Financial Crisis: Economic and Political Aspects

Edgar J. Saucedo Acosta Samantha Rullan

European Financial Crisis: Economic and Political Aspects

Universidad Veracruzana

Universidad Veracruzana Sara Ladrón de Guevara Rectora

Leticia Rodríguez Audirac Secretaria Académica

Clementina Guerrero García

Secretaria de Administración y Finanzas

Octavio Ochoa Contreras Secretario de la Rectoría

Édgar García Valencia Director Editorial

European Financial Crisis: Economic and Political Aspects

Edgar J. Saucedo Acosta Samantha Rullán

2016

Diseño de colección: Enriqueta del Rosario López Andrade Clasificación LC: Clasif. Dewey: Autor: Título: Edición: Pie de imprenta: Descripción física: Serie: Nota: ISBN: Materias: Autor relacionado:

HB3782 S28 2016 330.94 Saucedo Acosta, Edgar Juan European financial crisis : economic and political aspects / Edgar J. Saucedo Acosta, Samantha Rullán. Primera edición. Xalapa, Veracruz : Universidad Veracruzana, Dirección Editorial, 2016. 157 páginas : ilustraciones, tablas ; 23 cm. (Textos universitarios) Incluye bibliografías. 9786075024776 Crisis financiera-- Europa--Siglo XXI Política monetaria--Europa--Siglo XXI Europa--Condiciones económicas--Siglo XXI Europa--Política y gobierno--Siglo XXI Rullán, Samantha.

Este libro se realizó con el apoyo de fondos PIFI 2014

Primera edición, 14 de julio de 2016 D.R. © Universidad Veracruzana Dirección Editorial Hidalgo 9, Centro, Xalapa, Veracruz Apartado postal 97, CP 91000 [email protected] Tel/fax (228) 818 59 80; 818 13 88 ISBN: 978-607-502-477-6 Impreso y hecho en México Printed in Mexico

To Frida E.J.S.A. To Kamila S.R.

Brief Contents

List of Figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . List of Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . List of Abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Acknowledgements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15 19 21 23 27

PART I: Financial Crisis at European Level . . . . . . . . . . . . . . . . . . . . . . . . 1. Impacts of the European financial crisis: European Parliament elections and European macroeconomics . . . . . . . . . . . 2. European political and economic reconfiguration from the financial crisis: Is Berlin the new European economic capital? . . 3. Testing the regional leadership of the European Central Bank during the financial crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

31

PART II: Financial Crisis in Greece and Spain . . . . . . . . . . . . . . . . . . . . . 4. European financial crises: The Greek case . . . . . . . . . . . . . . . . . . . . . 5. Euro area governance in times of crisis: Enough for Greece and Spain? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6. Economic and political impacts of the European financial crisis in the autonomous communities of Spain . . . . . . .

33 55 65 89 91 107 129

Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

Contents

List of Figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . List of Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . List of Abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Acknowledgements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15 19 21 23

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Context of the European crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purpose of the book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Structure of the book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27 27 28 28

PART I: Financial Crisis at European Level . . . . . . . . . . . . . . . . . . . . . . . . . 31 1. Impacts of the European financial crisis: European Parliament elections and European macroeconomics . . 33 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 European Parliament elections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 European macroeconomics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 2. European political and economic reconfiguration from the financial crisis: Is Berlin the new European economic capital? . . . 55 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

Reconfiguration of the Franco-German axis during the sovereign debt crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reconfiguration of the European Central Bank after the sovereign debt crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

56 58 61 63

3. Testing the regional leadership of the European Central Bank during the financial crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 Conceptual framework: Global and regional leadership in the context of central banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 The European Central Bank during the crisis . . . . . . . . . . . . . . . . . . . . 68 Empirical analysis of the regional leadership . . . . . . . . . . . . . . . . . . . . 73 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 PART II: Financial Crisis in Greece and Spain . . . . . . . . . . . . . . . . . . . . . . 89 4. European financial crises: the Greek case . . . . . . . . . . . . . . . . . . . . . 91 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 Greek economic and financial crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . 92 Key players in the crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 The bailout and its economic consequences . . . . . . . . . . . . . . . . . . . . 100 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 5. Euro area governance in times of crisis: Enough for Greece and Spain? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Theory of optimum currency areas . . . . . . . . . . . . . . . . . . . . . . . . . . . Economic governance in the euro area during the crisis . . . . . . . . .

107 107 108 112

Comparative analysis of Spain/Greece and the United Kingdom/ Sweden: Monetary policy in times of crisis . . . . . . . . . . . . . . . . . . . . 115 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 6. Economic and political impacts of the European financial crisis in the autonomous communities of Spain . . . . . . . . . . . . . . . 129 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129 Regional effects of the global financial crisis . . . . . . . . . . . . . . . . . . . 131 Regions in Spain: main facts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136 Political effects in autonomous communities of Spain . . . . . . . . . . . . 140 Economic effects in the autonomous communities of Spain . . . . . . . 143 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

List of Figures

1.1 Seats (%) by political group in the European Parliament . . . . . . . . . . . 35 1.2 % of change in European Parliament elections by political group, 2009-2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 1.3 Seats (%) by political group in United Kingdom in European Parliament elections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 1.4 Seats (%) by political group in Germany in European Parliament elections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 1.5 Seats (%) by political group in France in European Parliament elections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 1.6 Seats (%) by political group in Portugal in European Parliament elections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 1.7 Seats (%) by political group in Spain in European Parliament elections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 1.8 Seats (%) by political group in Greece in European Parliament elections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 1.9 Seats (%) by political group in Ireland in European Parliament elections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 1.10 Seats (%) by political group in Italy in European Parliament elections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 1.11 Seats by political group (against current European integration or Eurosceptic) in European Parliament elections . . . . . . . . . . . . . . . . . . . . 45 1.12 Economic growth in the euro area, United Kingdom, United States and the World and forecasts from 2017 to 2021 . . . . . . . . . . . . . . . . . . . 47 15

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1.13 Government debt (% GDP) in the United States, United Kingdom, Major advanced economies (G7) and the Euro Area . . . . . . . . . . . . . . . 48 1.14 Government debt (% GDP) of some Euro Area countries . . . . . . . . . . . 49 1.15 Unemployment rate of selected Euro Area countries . . . . . . . . . . . . . . . 50 1.16 Unit Labor Costs (nominal) of some euro area countries . . . . . . . . . . . 51 3.1 Words (group 1) mentioned per press conference . . . . . . . . . . . . . . . . . 78 3.2 Words (group 2) mentioned per press conference . . . . . . . . . . . . . . . . . 79 3.3 Words (group 3) mentioned per press conference . . . . . . . . . . . . . . . . . 80 3.4 Words mentioned per press conference by the presidents of the European Central Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 3.5 Percentage use of the main world currencies as international reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 3.6 Percentage use of euro as international reserves around the world . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 3.7 Indicator of acceptance of the regional leadership of the European Central Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84 4.1 Greek government general gross debt (%GDP) 1980-2015 . . . . . . . . . . . 93 4.2 General Greek, German and Spanish government gross debt (% GDP) 1999-2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94 4.3 Nominal unit labor costs in Germany, Greece, Ireland, Italy, Spain and United Kingdom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 4.4 GDP Growth (%) Denmark, Greece, Sweden and United Kingdom . . 102 4.5 GDP Growth (%) Cyprus, Greece, Ireland, Portugal and Spain . . . . . 103 5.1 Reference interest rate: European Central Bank, Bank of England and RiksBank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118 5.2 Gross domestic product (constant prices) . . . . . . . . . . . . . . . . . . . . . . . 119 5.3 Unemployment rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 5.4 Gross government debt (% GDP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 5.5 Public deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122 5.6 Long-term interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 5.7 Effective exchange rate index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 6.1 Economic growth: Spain and the European Union . . . . . . . . . . . . . . . 132 6.2 Unemployment rate: Spain and the European Union . . . . . . . . . . . . . 133

EUROPEAN FINANCIAL CRISIS: ECONOMIC AND POLITICAL ASPECTS

17

6.3 Spanish autonomous communities and cities by population 2011 . . . 138 6.4 Percentage of GDP of Spanish autonomous communities and cities 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 6.5 Coefficient of variation of unemployment rate of Spanish communities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144 6.6 Coefficient of variation of GDP per capita of Spanish communities . . 145 6.7 Changes in employment in the manufacturing sector in Spanish communities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146 6.8 Changes in employment in the construction sector in Spanish communities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147 6.9 Changes in employment in the hospitality sector in Spanish communities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148 6.10 Changes in employment in the public sector in Spanish communities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149 6.11 Coefficient of variation of the unemployment rate . . . . . . . . . . . . . . . . 150

List of Tables

1.1 Unemployment rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 3.1 Dollar swap announcements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 3.2 Reference interest rate: The Federal Reserve, European Central Bank, Bank of England and Riksbank . . . . . . . . . . . . . . . . . . . . . . . . . . 72 3.3 Values of exchange rate regimes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76 3.4 Global analysis of regional leadership of the European Central Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 5.1 Monetary and exchange rate policies: The Federal Reserve, European Central Bank, Bank of England and Riksbank . . . . . . . . . 116 6.1 Regions (NUTS 2) with the highest unemployment rate in the European Union 27 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 6.2 Countries in the European Union 27 with a smaller population than Andalusia, 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 6.3 2007 and 2011 regional elections in 13 Spanish autonomous communities and 2 cities by winning political party and number of seats obtained . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140 6.4 2009 European elections summary table of results in Spain . . . . . . 143 6.5 Changes in unemployment rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152

19

List of Abbreviations

BIS BoC BoE BoJ CBPP1 CETES ECB Ecofin EFSF EMU ERM ESM EU FED FOBAPROA GDP IMF IOs LTRO MBS MRO NAFTA OCA OECD OMT PDCF

Bank for International Settlements Bank of Canada Bank of England Bank of Japan Covered Bond Purchase Program Treasury Certificates European Central Bank Council of Economic and Financial Affairs European Financial Stability Facility Economic Monetary Union Exchange Rate Mechanism European Stability Mechanism European Union Federal Reserve, the Banking Fund for the Protection of Savings Gross Domestic Product International Monetary Fund International Organizations Long Term Refinancing Operations Mortgage Backed Securities Main Refinancing Operation North American Free Trade Agreement Optimum Currency Areas Organization of Economic Cooperation and Development Outright Monetary Transactions Primary Dealer Credit Facility 21

22

PP PSOE QE Riksbank SGP SMP SNB TAF TESOBONOS TFEU UK ULC UN US WB

EDGAR J. SAUCEDO ACOSTA, SAMANTHA RULLÁN

People’s Party Spanish Social Workers’ Party Quantitative Easing Sweden Central Bank Stability and Growth Pact Securities Market Programme Swiss National Bank Term Action Facility Bonds Federal Treasury Treaty on the Functioning of the European Union United Kingdom Unit Labor Costs United Nations, the United States, the World Bank, the

Acknowledgements

In early 2012, when the financial crisis was at its peak and the risk premium of most peripheral European countries was at record levels, we discussed the importance of the events and their consequences. Initially, we started to prepare papers and then we sent them to international conferences in different European countries, during the years 2012 and 2013. Subsequently, in 2014 and part of 2015 the book was edited. The book has six chapters, which were presented at the following conferences: Chapter 1:1st Dubrovnik International Economic Meeting (DIEM 2013): Scientific Conference on Innovative Approaches to the Contemporary Economic Problems. University of Dubrovnik, Dubrovnik, Croatia, 27th-29th September 2013. An earlier version was published in: Business Systems Research Journal, Vol. 5, No. 2 (2014). The chapter's version of the book includes an updated economic data to 2016 and the results of the elections of the European Parliament of 2014. Chapter 2: 2º Coloquio de Investigación en Administración y Gestión para el Desarrollo: “Gestión y gobernanza: actores e instituciones”. University of Veracruz, Xalapa, Mexico, 17th-18th October 2013. A Spanish version was included in the conference proceedings of the colloquium. Chapter 3: Case Study Integrity Forum on Regional Governance and Global Crisis. Central European University, Budapest, Hungary, 11-12 April, 2013. Chapter 4: The Financial Crises in Comparative Regional Perspective: Can Europe Learn from Other Regions?.Freie Universität Berlin, Berlin, Germany, 23rd-24th November 2012. An earlier version was published in: CONfines, issue 19 (2014). The chapter's version of the book includes an updated economic data to 2016 and more European countries were included(in the analyses). We have eliminated the comparison with Mexico. 23

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Chapter5: 8th Pan - European Conference on International Relations: One International Relations or Many? Multiple Worlds, Multiple Crises. University of Warsaw, Warsaw, Poland, 18th-21st September 2013. Chapter 6: 9th European Urban & Regional Studies Conference: Europe and the World: Competing Visions, Changing Spaces, Flows and Politics. University of Sussex, Brighton, United Kingdom, 10th-12th July, 2013. The book can be used for undergraduate and graduate students, and students from any area of knowledge. This text has a Latin American perspective of the European crisis due to the authors are Latin Americans. By using a Latin American perspective, we believe that the book contributes to the written books about the European crisis, and we believe that this text is a valuable input to Latin American and European students as well as researchers from both continents. We would like to thank the following people, who made comments and observations on some of the chapters: ArieKrampf (Senior Lecturer at the Academic College of Tel Aviv-Yaffo), Barbara Fritz (FreieUniversität Berlin), ZsoltDarvas (Bruegel), Sebastian Krapohl (University of Bamberg) and Ivona Vrdoljak Raguž (University of Dubrovnik). We thank two peer reviewers of this book: one from the International Monetary Fund and another form Metropolitan Autonomous UniversityIztapalapa (Department of Economics) We would also like to acknowledge the following institutions for their financial support for the presentations and the publication of the book: • National Council for Science and Technology (Mexico): for the financial support of one-year postdoctoral fellowship to Edgar J. Saucedo A. at UNU-CRIS (Belgium) • Kolleg-Forschergruppe "The Transformative Power of Europe" (Germany): financial support to attend a conference at Free University of Berlin (Germany). • United Nations University-Comparative Regional Integration Studies (Belgium): financial support to attend a conference at the Central European University (Hungary). • Ministry of Education "Strengthening of Quality in Educational Institutions Program (PROFOCIE)" (Mexico): financial support to attend a conference at Sussex University (UK). • University of Veracruz "General Directorate of Research” (Mexico): financial support to attend a conference at the University of Warsaw (Poland).

EUROPEAN FINANCIAL CRISIS: ECONOMIC AND POLITICAL ASPECTS

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• University of Veracruz "Support from the President of the University" (Mexico): financial support to attend a conference at the University of Dubrovnik (Croatia). • Ministry of Education “Strengthening of Quality in Educational Institutions Program (PROFOCIE)" (Mexico): financial support to publish this book.

Introduction

Context of the European crisis The financial crisis, which started in the housing sector in the US, has had multiple global effects. Such a crisis has affected the developed countries more than the emerging countries. For Europe, the crisis has had economic, political and institutional effects. The institutional design of the euro area has been reconfigured with the crisis, because the institutions of the EU were re-designed, as they were not conceived for scenarios that occurred with the sovereign funding crisis. From mid-2008 to date, the European crisis has generated a historic fall of GDP, in Greece where GDP has accumulated 5 consecutive years of decline (by the end of 2014 there had been economic growth). On the other hand, Greece and Spain had higher levels of unemployment (close to 28%), higher in other segments of society, such as young or regional level (NUTS II), as in Andalusia (Spain) and Central Greece (Greece). The establishment of rescue funds for countries with liquidity problems and bond purchases by the European Central Bank (ECB) has generated various interpretations of the treaties. Several funds were created; the first two were temporary, while the third was permanent, so that countries facing liquidity problems could fulfill their commitments to bondholders. The Bundesbank has questioned whether the treaties allow the ECB to stabilize the risk premium of the peripheral countries. On the other hand, from January 22, 2015 the ECB launched the first massive purchases of financial assets (Quantitative Easing), which include monthly purchases of sovereign debt in order to reverse the low inflation in the euro area (well below the ECB's target of close to, but below 2%). On January 25, 2015, SIRIZA (radical left party) won the elections in Greece and formed a coalition government, while in Spain Podemos ob27

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tained 21.1% of the total votes in the election of June 2016 (only 1.5% below the second place, PSOE). Both parties are against the austerity policies implemented by the troika. Moreover, in elections to the European Parliament in mid-2014, the National Front won in France, and the UK Independence Party had historic results, both parties openly anti-Europeanists. The above shows the political effects of the financial crisis in several European countries in addition to the preference of the electorate by political parties opposed to austerity policies and those parties with ideas contrary to European integration. Purpose of the book The aim of the book is twofold: the first objective is to show that the European financial crisis has had political effects, early elections driven by the implementation of austerity policies, as well as economic effects, such as the fall in GDP, increase in the unemployment rate and the risk premium. The second aim of this paper is to highlight that effects (political and economic) have been differentiated, due to the fact that there is a group of countries where unemployment has barely increased (in Germany it has even declined) and risk premiums stayed low, and a second group of European peripheral countries, where unemployment rates have reached historic levels and which had to be rescued by European funds. To meet both objectives, we discuss economic and political aspects of the European crisis, and then we compare countries with better economic performance with a group of peripheral countries. We analyze the role of the European countries with greater political power as well as the political and economic reconfiguration that has occurred in the EU from the crisis. We investigate the role of the ECB during the crisis. Finally, the book focuses on the effects of the crisis in countries like Greece and Spain.

Structure of the book The book is divided into two parts. The first discusses the crisis at European level, highlighting the differences between countries as well as the roles of Germany and the ECB during the crisis. The second part focuses on two countries (Spain and Greece) that have been more severely affected by the crisis. The first chapter discusses how the financial crisis affected the EU. The analysis focuses on the political and macroeconomic consequences of the

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crisis. The central idea of the chapter is that the European financial crisis was a consequence of the high level of debt and the deficit of some peripheral countries (mainly Greece), but also due to the weak European governance, which was not prepared for a crisis of such magnitude, where spillover effects of peripheral countries were too big for the rest of the EU. The main macroeconomic consequences of the crisis are: (1) a decline in production not seen since the Great Depression, furthermore this fall was differentiated after 2010 (the peripheral countries were the most affected), (2) an increase in the unemployment rate in the EU, which further exacerbated in countries with rigid labor markets, as in the case of Spain and Greece, (3) an increase in the risk premium of peripheral countries and their subsequent bailouts, and (4) the implementation of austerity measures in European peripheral countries as a condition for bailouts. The main political consequences of the crisis were: (1) in the European Parliament elections won anti-European political parties, (2) Traditional (European) political parties obtained a lower percentage of votes. In the second chapter we analyze the reconfiguration of the Franco-German axis during the crisis. Before the crisis the main decisions in the EU were taken jointly by Paris and Berlin, since the crisis the situation changed. Berlin has become the new European capital, because its political and economic power has increased. The increasing power of Germany can be explained by the following reasons: (1) Germany is the largest contributor to the bailout funds, so the negotiations of the rescued countries pass through Berlin, and the latter even outweighs Brussels, because the funds are not properly from the EU but its members, (2) Germany has a lower risk premium, while France recorded some rises during the crisis, which increased the bargaining power of Berlin, (3) Chancellor Angela Merkel has been one of the few heads of government in the EU who has won two elections during the crisis, and (4) the Bundesbank has been very influential in the decisions of the ECB during the crisis. Chapter three examines whether the ECB has held regional leadership in Europe. We start from a theoretical approach to measure the regional leadership of the countries in the international relations, and there are three elements that determine the regional leadership: willingness, ability and acceptance. In this chapter, the three concepts are quantified and compared between the ECB and the FED. The ECB's reply was late compared to the FED, due to legal restrictions to take unorthodox measures and the level of conservatism of the ECB’s members. The FED reached global leadership by the speed of its measures, while the ECB failed to achieve regional leadership for its lack of flexibility, and even in Europe itself, the BoE and the Bank of Sweden reacted faster and with greater flexibility.

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In chapter four we perform an analysis of the Greek crisis 2008-2016. We started noting that the measures taken by the European institutions in Greece were not suitable. The results show that the Greek bailouts occurred in a global crisis with a generalized credit crunch, so it was not easy to rescue Greece because credit was limited. Greece has had seven years of economic decline and a fixed exchange rate (Greece uses the Euro). In chapter five the weak European governance is presented as a factor that worsened the crisis in peripheral countries such as Greece and Spain. The central point is that the euro area is a monetary union without fiscal union, which makes it vulnerable to countries that cannot issue debt in their own currency. Countries such as Greece and Spain cannot issue debt in local currency but there is no central mechanism in the euro area to implement a fiscal policy that supports countries in crisis. In this chapter we compare the UK and Sweden to Greece and Spain, because the first countries still have their own national currencies, while the latter use the euro. The results show that the economic performance of the UK and Sweden has been better than Greece and Spain, and that the first group of countries have more flexible monetary and exchange rate policies that enabled them to respond to crises more effectively and timely. European economic governance has been weak and countries like Spain and Greece have suffered because it does not allow European institutions to respond quickly and with unorthodox measures to unforeseen crises. In the last chapter we analyze the political and economic effects of the European crisis in the Spanish autonomous communities. Spain (and also Greece) has been affected by the crisis (high unemployment), but in some Spanish regions the crisis has been even more severe. Andalusia is one of the most populated regions of Spain with unemployment rates that reached levels close to 40%, while the national average was 27%. The Spanish regions most related to the housing sector were those who had the worst declines in employment. In the political sphere, the communities governed by the Spanish Socialist Workers Party (PSOE) during the crisis had changes of government, due to the effects of the austerity measures implemented since Madrid.

Part 1 Financial Crisis at European Level

1

Impacts of the European financial crisis: European Parliament elections and European macroeconomics

Introduction Ten years after the euro officially came into existence, the EU was confronted with a banking and sovereign debt crisis that had substantial spillover effects on national politics and the quality of life of most citizens. When the euro was launched in early 1999, some experts were optimistic about this important development viewed by many as a powerful sign of a closer European integration. As a major development, the introduction of the euro brought certain expectations such as: to increase cross-border competition, promote structural reforms and displace the dollar as the most traded currency in the world. For a while, investors believed that the risk associated to all members of the euro area was practically the same and it became cheaper for countries such as Greece to borrow from the international market. In 2009, the risk premium soared for peripheral countries. The depth and severity of this crisis is disturbing. The economic and political consequences of the crisis are pervasive. Even a small euro area country with economic problems can destabilize a larger country and the financial instability can become widespread. In addition, the European institutions have been criticized for not responding assertively and appropriately to the crisis. Greece (2010), Ireland (2010), Portugal (2011), and Cyprus (2012) have been bailed out, and Spain (2012) received a more limited banking sector support. European voters have punished governments in all peripheral euro area countries and there have been important changes. In Spain, Mariano Rajoy, from the PP won the 2011 elections in Spain after almost eight years of a left wing government led by Jose Luis Rodriguez Zapatero. The case of France is also interesting, in 2012, Sarkozy, from a center-right party (UMP), was the first incumbent defeated since 1981 and Francois Hollande, representing the 33

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socialist party, became the first President of France since Mitterrand. This shift in power also had an impact on the Franco-German axis; Sarkozy was a crucial ally of Angela Merkel while Hollande’s difference of opinion with regards to the European crisis made it difficult for them to find a common ground. The European crisis has had an adverse impact on most member states and countries in the euro area have been particularly affected. However, peripheral countries such as Portugal, Ireland, Greece, Latvia (it was not in the euro area, but had a hard peg exchange rate regime) and Spain have been the worst hit countries in the EU. This crisis introduced not only economic but also political and social problems. The weak economic governance in the euro area largely contributed to the crisis and the Troika (ECB, European Commission and the IMF) was formed to organize the bailouts. The political consequences of the crisis were substantial and led to power shifts in many European countries among them Portugal, Ireland, Spain, Greece and Italy. The population did not welcome the austerity measures introduced by the Troika and many protests ensued. Nevertheless, without programs, austerity would have been even more difficult, because primary deficits would have had to fall to zero immediately (if countries would like to remain in the euro area).Concerning the social consequences of the crisis, in mid-2013 the unemployment rate in Spain was 26.7% and in Greece 27.3%. Scholars have debated the main causes and consequences of the European crisis. Some of them focused on the economic effects, others on the political impact, and several on the social implications. This paper emphasizes the macroeconomic and political (in the European parliamentary elections)consequences of the crisis, focusing on the strong link between them. Certain European governments were forced to relinquish power due to the implementation of austerity measures by the Troika while in other countries the crisis exacerbated their existing problems and heads of state or government had to resign. Overall, the crisis has exhibited the failures of the European economic governance to respond promptly and adequately when faced with an important challenge. The negative effects of this crisis were not only present in the economy but also permeated on national politics. A stronger economic governance and greater economic policy coordination is essential for the EU. European Parliament elections The first impact of the European financial crisis on the European Parliament elections (in 2014) was that the large political groups, such as the Europe-

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an People's Party and Socialists and Democrats, won fewer deputies. These groups of parties have had a reduction in the number of deputies in the European Parliament. Figure 1.1 Seats (%) by political group in the European Parliament

Source: European Parliament

The second impact of the financial crisis was that parties that are against European integration or Eurosceptic had a greater number of deputies. The following figure shows that parties such as the European Conservatives and Reformists, (ECR) European Union Left / Nordic Green Left (GUE / NGL) and Europe of Freedom and Direct Democracy Group (EFDD) had a higher percentage of deputies in the European Parliament In 2014 (compared to 2009). These parties are from the extreme left and the extreme right, but share their doubts to the current European integration.

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Figure 1.2 % of change in European Parliament elections by political group, 2009-2014

Source: European Parliament

We selected the following countries: United Kingdom, Germany, France, Portugal, Spain Greece, Ireland and Italy. The first country was chosen because it is the largest economy in the EU that does not use the euro, which was able to use its own monetary policy in times of crisis. Germany and France were chosen because they were countries that contributed the most for the bailout funds, while the following 4 countries were chosen because they were bailed out and conditioned by austerity policies. Finally, although Italy was not bailed out, such country had a considerable increase of its risk premium.

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Figure 1.3 Seats (%) by political group in United Kingdom in European Parliament elections

Source: European Parliament

In the United Kingdom, the political group of Europe's Freedom and Direct Democracy group (EFDD) had a considerable increase in the number of deputies between 2009 and 2014. The winner of European elections was the United Kingdom Independence Party (UKIP), because it won to the Labor Party (belonging to the S&D group) and the Conservatives (belonging to the ECR). UKIP was one of the drivers of the "yes" to the referendum that Britain leaves the EU. Without the European financial crisis, it would have been more difficult for the referendum to take place.

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Figure 1.4 Seats (%) by political group in Germany in European Parliament elections

Source: European Parliament

In Germany, the biggest impact of the European financial crisis was that the ruling party (Christian Democratic Union belonging to the group of EPP) lost seats in the European Parliament, while the Social Democratic Party (which belongs to the S&D group) won more seats in 2014 (compared to 2009). However, the Democratic and Christian Union won first place, while the second was for the Social Democratic Party.  

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Figure 1.5 Seats (%) by political group in France in European Parliament elections

Source: European Parliament

In France, large parties in that country lost seats in 2014 compared to 2009. The winning party was the National Front (which belongs to the group of non-attached members), an extreme right party, which won to the Union for Popular Movement (Belonging to the EPP group) and the Socialist Party (belonging to the S& D group). The National Front is a party opposed to the process of European integration since its birth

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Figure 1.6 Seats (%) by political group in Portugal in European Parliament elections

Source: European Parliament

In Portugal was presented a coalition composed of the Social Democratic Party, the Social Democrat Center / Popular Party (belonging to the EPP group) in 2014, that lost seats in relation to 2009. The Socialist Party (which belongs to S&D) had an increase in deputies that allowed it to be the first force in the elections of the European Parliament of 2014.

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Figure 1.7 Seats (%) by political group in Spain in European Parliament elections

Source: European Parliament

In Spain, large parties such as the Popular Party (belonging to the EPP) and the Socialist Party (belonging to S&D) had a drop in the number of deputies in the European Parliament in 2014 compared to 2009. The GUE / NGL political group presented the largest increase in the number of seats, due to the emergence of political parties like "Podemos", which are against the current state of European integration.  

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Figure 1.8 Seats (%) by political group in Greece in European Parliament elections

Source: European Parliament

Greece is the country of the EU where the political effects of the European financial crisis were more noticeable. Large political parties such as PASOK (belonging to the S & D political group) and New Democracy (of the EPP political group) had a considerable drop in the number of deputies in the 2014 election compared to 2009. PASOK went from having eight to zero deputies, while the New Democracy went from 8 to 5 deputies. On the other hand, Syriza (belonging to the GUE / NGL group) ranked first in the 2014 elections, a political party opposed to the current state of European integration. Besides that Golden Dawn, extreme right political party and opposed the membership of Greece to the EU, It obtained 3 parliamentarians (belonging to the group of non-attached members).

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Figure 1.9 Seats (%) by political group in Ireland in European Parliament elections

Source: European Parliament

In Ireland the political party "Fine Gael Party" (which is part of the EPP) increased the number of deputies in the European Parliament in 2014 compared to 2009, although it was a statistical effect because it obtained the same number of seats (4) in both years, what happened was that Ireland went from having 12 European deputies to 11. On the other hand, the Labor party had a reduction in votes (it forms part of the S&D) in 2014. The S&D political group had a considerable reduction in the number of deputies, from having 4 in 2009 to 1 in 2014. Finally, Sinn Féin was the party that had the largest increase in deputies in 2014 compared to 2009, because it obtained 3 deputies in 2014 and 0 in 2009, in addition to the European political group of GUE / NGL went from 1 to 4 deputies.  

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Figure 1.10 Seats (%) by political group in Italy in European Parliament elections

Source: European Parliament

In Italy, the Five-Star Movement (belonging to the EFDD group) had the largest increase in deputies, as it rose from 0 to 17 deputies in 2014 compared to 2009, while the Democratic Party (belonging to the S&D group) increased from 21 to 31 deputies in the same period. The Five Star Movement is Eurosceptic, so one of the main political consequences of the European financial crisis in Italy was the decision of a percentage of Italian citizens to vote for political party that are against European integration.

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Figure 1.11 Seats by political group (against current European integration or Eurosceptic) in European Parliament elections

Source: European Parliament

Finally, the above graph shows the European deputies of political parties that are against the current process of European integration (only some of the most mentioned ones were included). In 2009, these parties had only 17 European deputies, while 2014 80 European deputies were elected. On the other hand, due to the European financial crisis, the Five Star Movement was born in Italy, Podemos in Spain and Golden Dawn in Greece. In addition to being strengthened political parties such as the National Front in France and UKIP in the United Kingdom. European macroeconomics The EU is facing one of the worst economic crises of the past 60 years of history. The current crisis has placed the EU in a vulnerable position regarding international investors and demonstrated the system failures of an incomplete Monetary Union. The European economic governance has been seriously questioned for its lack of reaction towards recent problems.

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The current crisis is the product of two crises: the financial crisis that began in September 2008 with the Lehman Brothers’ bankruptcy in the US which rapidly spread to the rest of the world, and the sovereign debt crisis that initiated in October 2009 when the former Greek Prime Minister Georgios Papandreou stated that the Greek public deficit was higher than what had been announced months before by the previous prime minister. The 2009-2012 period has been catastrophic for the EU in general, but mainly for the peripheral countries because they have fallen into an economic downturn. The launch of the euro impacted on the risk associated with each of the countries belonging to the euro area; there was a convergence in the risk premium among all members of the EMU. In order to enter the EMU, euro area members have to pass the same economic tests, but the different characteristics of the economies of the euro area do not correspond to the same risk. Interest rates on bonds of euro area governments converged from 1995 to1999. Since 1999, the risk associated with the bonds of euro area governments had been practically the same. The fact is that although 12 countries shared the same currency, their economies did not necessarily have the same conditions. There are economies like Germany and Finland with high competitiveness, which contrasted to others like Greece and Spain with low competitiveness. Nevertheless, Spain was probably competitive in 1999, Germany not so much, but then over time wage increases in the south were much higher than in the north reversing the situation. In late 2008, the credit fell and investors observed the public finances of governments very closely. From 2009 the risk premium increased for peripheral countries like Greece, Ireland, Portugal, and to a lesser extent, Italy and Spain, but in the summer of 2012, the risk premium of the latter countries reached record levels. The ECB's decision to buy an unlimited debt in the secondary market in September of 2012 helped reduce the risk premium of the peripheral countries of the euro area, so that for the first quarter of 2013, there was a significant decrease in the risk premium. The ECB considered that interest rates in the periphery were too high relative to the risks, possibly because speculators started doubting the future of the euro area. The economies of Ireland and Spain have already been bailed out in order to stabilize their financial and banking systems. In the case of Spain, there was a restructuring of the banking system, which included mergers, due to problems of capitalization of banks. In addition, so-called "Cajas", aggravated the problem because those institutions failed to get international financing, while the bailouts in Greece and Portugal have been implemented to generate solvency because these economies did not have enough liquidity to cover the payment of short-term bonds. In all four cases, the bailouts were imple-

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mented after a significant increase in the risk premium. Before the financial crisis broke, the euro area economy was growing around 2% per year. However, in 2009 there was a drop in the economic activity of 4%. Figure 1.12 shows the economic growth in the euro area and forecasts from 2017 to 2021. This figure illustrates how, after the fall in the economic activity of 2009, there was another descent to a lesser extent in 2012, the latter as a result of the sovereign debt crisis in peripheral countries. According to the IMF, the forecast of economic growth for the euro area in the coming years will be below 1.5%. Figure1.12 Economic growth in the euro area, United Kingdom, United States and the World and forecasts from 2017 to 2021

Source: International Monetary Fund, World Economic Outlook Database, April 2016.

Some experts have mentioned that the economic crisis in the euro area is a result of high spending in recent years. However, when comparing debt (% GDP) in the euro area with the US, from 2000 to 2008 the euro area debt remained stable (Figure 1.13). The increase in debt, as a result of the financial crisis in late 2008, was lower in the euro area than in the US, so that argument is not entirely valid.

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Figure 1.13 Government debt (% GDP) in the United States, United Kingdom, Major advanced economies (G7) and the Euro Area

Source: International Monetary Fund, World Economic Outlook Database, April 2016.

Public debt in the euro area members varies considerably with the euro area average. Figure 1.14 shows the public debt (% GDP) of some euro area members. Countries like Greece and Italy have public debt with values close to 100% (% GDP) since 2000, while other countries in Figure 1.3 have had values close to 60% until 2008. With the financial crisis almost all countries increased their public debt, however, countries like Greece, Ireland, Spain and Portugal had sharp increases. The sovereign debt problem is not due to the fact that the euro area has overspent, but some peripheral countries recorded increases in public debt. In the US some states spend more than the average. However, the difference from the EU is that there is an adjustment mechanism that serves the states with economic troubles, whereas in the EU there is no such mechanism. The US has a centralized budget that is more than 20% of its economy, while the EU’s budget is 1% (fiscal policy remains at national level). Although the ESM was created, it cannot be compared to the adjustment mechanisms that exist in the US. In the EU, each country has its financial system that is heavily invested in bonds of its own government, so a government bankruptcy has dramatic consequences. In the U.S. if a state were to go bankrupt, its bonds would be a small share of the assets of U.S. banks.

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Figure1.14 Government debt (% GDP) of some Euro Area countries

Source: International Monetary Fund, World Economic Outlook Database, April 2016.

The impact of the sovereign debt crisis has hit European countries differently. On the issue of unemployment is where the greatest differences were noticed in the euro area, because labor markets in the euro area have different degrees of flexibility (Bernal-Verdugo, Furceri & Guillaume, 2012). Figure 1.15 shows that Spain and Greece had high unemployment rates in 2012, with levels close to 25%, while Germany had an unemployment rate very close to 5%. Figure 1.15 also shows that from 2008 there has been a substantial increase in the unemployment rate in countries like Spain, Greece and Portugal, while in Germany it has decreased.

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Figure 1.15 Unemployment rate of selected Euro Area countries

Source: International Monetary Fund, World Economic Outlook Database, April 2016.

Table 1.1 shows the current and projected unemployment rates in 2013 and 2018. The euro area will have an reduction in the unemployment rate in 2018, but other countries will have a reduction from -3.28 (US) to -0.78 (Canada). Therefore, in 2018 unemployment will remain a great issue across Europe. Table 1.1 Unemployment rates Country / Date United States Canada OECD Japan Euro Area United Kingdom

Current (Q-1 2013) 7.74 7.14 8.05 4.22 12.01 7.85

Projected (Q-4 2018) Change (points) 4.45 -3.28 6.36 -0.78 5.94 -2.11 2.86 -1.36 9.00 -3.02 5.89 -1.96

Source: OECD Short-Term Labor Market Statistics) and OECD Economic Outlook Databases

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The underlying problem in the euro area is the competitive gap among member states. Figure 1.16 shows that ULC vary significantly in the euro area because while in Germany the ULC have been decreasing considerably in the last decade, hence becoming one of the most competitive countries, in Spain, Greece, Ireland and Italy their ULC have increased in the last decade. Since 2009, most countries in Figure 1.16 show a significant reduction of ULC. The difference in the competitiveness of euro area countries is significant, and it is one of the variables that explain the vulnerability in that area. Although members of the euro area share the same currency, the economic and financial results are different. Therefore, the financial problem of a small country can affect the entire euro area, while in the US, financial problems or a competitiveness gap in the states have no effect on the whole country because there is an adjustment mechanism on a centralized budget, which is greater than the one that exists in the EU. Figure 1.16 Unit Labor Costs (nominal) of some euro area countries

Source: AMECO Database, European Commission

The issue of moral hazard has been mentioned in the bailouts that have occurred in the euro area(Jones (2010); De Grauwe, 2011b). Countries that provide money for bailouts, like Germany, have no incentive to grant money, because it creates the risk of generating bad behavior in countries that re-

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ceive the money. The outcome shows that there is moral hazard: solidarity is more complicated when the Federal State does not have a centralized budget. Nevertheless, nowadays the argument of moral hazard is overdone, given Greece’s experience. Gros & Mayer (2010) suggest the creation of a European Monetary Fund as a measure to bail out European countries. Other authors have highlighted that Europe needs some kind of Political Union (De Grauwe, 2011a) and the joint issue of Eurobonds. The response of the European institutions has varied over time and has been differentiated. On the one hand, the ECB implemented programs to provide liquidity and to reduce the interest rate from the onset of the financial crisis. When the sovereign debt crisis began, the ECB bought government bonds to reduce risk premium, whereas in September of 2012 the President of the ECB bought the debt without limit, reducing the risk premium. On the other hand, the institutional response to stop public debt was the Treaty on Stability, Coordination and Governance, which further restricts the range of public deficit of the euro area countries. Since 2010, the Troika (the ECB, the European Commission and the IMF) insisted on implementing austerity policies to the bailed-out countries. However, there has been a change in the discourse when austerity measures were requested for longer periods and with more flexibility. The serious economic problems of Spain and Greece have caused a relaxation of the Troika in the pursuit of austerity. Conclusions The global financial crisis led to a global credit crunch, although in developed countries it was even deeper. Despite the fact that it initiated in the housing sector in the US, in 2009 most developed countries had a sharp drop in production. And Europe was no exception, with several variations, but all of the countries in the EU registered an economic contraction. The launch of the euro led to a convergence in the risk associated with the bonds of the euro area governments. The global financial crisis led to an increase in public debts in the euro area, which caused a boost of the risk premium, mainly in peripheral European countries. In 2010, a sovereign debt crisis began in the euro area and some countries were bailed out, like Portugal, Ireland, Spain, Greece and recently Cyprus. This crisis was not anticipated by the European institutions and they created new tools to help the economic governance of the euro area, most notably: The Treaty on Stability, Coordination and Governance, the ESM, the establishment of the Troika and a new temporal function de facto of the ECB (the unlimited purchase of gov-

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ernment debt in the secondary market). The crisis increased sovereign debt of countries like Greece, Portugal, Spain, and Ireland eventually leading them to request bailouts. The bailouts were granted with conditions i.e. implement austerity policies of public spending, cuts and tax increases, which would cause an even steeper drop in economic activity. The economic consequence of the financial crisis was such that the unemployment rate in countries such as Spain (27.17%) and Greece (24.5%) increased to historic levels, which has led to social discontent. The financial crisis caused a poor economic performance in the EU Member States, which led to alternation of political parties in governments where elections were held, as in the case of France and the UK, among others. Also in some cases, the economic impact of the crisis led to call snap elections, as in Spain and Greece, while in Italy, with a high risk premium, the former Italian Prime Minister Silvio Berlusconi was forced to resign and a technical government headed by Mario Monti was installed. The financial crisis in Europe lasted more than four years, unemployment increased mainly in the peripheral countries, there was an alternation of political parties in government and increased internal migration within Europe. Finally, the financial crisis led to an unfinished institutional change in the EU, which has been the result of different preferences with regards to economic austerity. The Franco-German axis has been reconfigured, some fissures have spawned as a result of the preference of Germany for austerity policies and France for economic growth.

References Bayoumi, T. & Eichengreen, B., 1997. Ever Closer to Heaven? An OptimumCurrency-Area Index for European Countries. European Economic Review, 41(3-5), pp. 761-70. Bernal-Verdugo, L. E., Furceri, D., & Guillaume, D., 2012. Labour market flexibility and unemployment: new empirical evidence of static and dynamic effects. Comparative Economic Studies, 54(2), pp. 251-273. Bordo, M. D., Meissner, C. M., & Stuckler, D., 2010. Foreign currency debt, financial crises and economic growth: A long-run view. Journal of International Money and Finance, 29(4), pp. 642-665. Dabrowski, M., 2010. The global financial crisis: Lessons for European integration. Economic Systems, 34(1), pp. 38-54. De Grauwe, P., 2011a. Managing a fragile Eurozone. CESifo Forum, 12 (2), pp. 40-45.

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De Grauwe, P., 2011b. The European Central Bank as a lender of last resort. VoxEU, 18th August. De Grauwe, P., & Ji, Y., 2013. Self-fulfilling crises in the Eurozone: An empirical test. Journal of International Money and Finance. 34, pp. 15-36. De Grauwe, P. & Heens, H., 1993. Real Exchange Rate Variability in Monetary Unions. Recherches économiques de Louvain, 59(1-2), pp. 105-17. Evans, G., 2002. European Integration, Party Politics and Voting in the 2001 Election. In L. Bennie, C. Rallings, J. Tonge, & P. Webb, eds. British Elections and Parties Review, London: Frank Cass, pp. 95–110. Featherstone, K., 2011. The JCMS Annual Lecture: The Greek Sovereign Debt Crisis and EMU: A Failing State in a Skewed Regime. Journal of Common Market Studies, 49(2), pp. 193-217. Fidrmuc, J. & Korhonen, I., 2003. Similarity of Supply and Demand Shocks Between the Euro Area and the CEECs. Economic Systems, 27(3), pp. 313-34. Gros, D., & Mayer, T., 2010. Towards a Euro(pean) monetary fund. CEPS Policy Brief, (202). Jones, E., 2010. A Eurobond proposal to promote stability and liquidity while preventing moral hazard. ISPI Policy Brief, (180). Kriesi, H., 2012. The political consequences of the financial and economic crisis in Europe: electoral punishment and popular protest. Swiss Political Science Review, 18(4): pp. 518-522. Lane, P. R., 2012. The European sovereign debt crisis. Journal of Economic Perspectives, 26(3), pp. 49-67. Lewis-Beck, M. S., & Nadeau, R., 2011. Economic voting theory: Testing new dimensions. Electoral Studies, 30(2), pp. 288-294. Mair, P., 2000. The limited impact of Europe on national party systems. West European Politics, 23(4), pp. 27-51. Singer, M. M., 2011. Who says “It’s the economy”? Cross-national and crossindividual variation in the salience of economic performance. Comparative Political Studies, 44(3), pp. 284-312. Saucedo, A. E., Bacaria, J. & J. C. Fortuno H., 2013. Los PIIGS en tiempos de crisis de deuda soberana: la pertinencia de usar el euro. Investigación Económica, 71(281), pp. 59-82. Sitter, N., 2001. The politics of opposition and European integration in Scandinavia: Is Euro–skepticism a government–opposition dynamic?. West European Politics, 24(4), pp. 22-39. Tillman, E. R., 2004. The European Union at the ballot box? European integration and voting behavior in the new member states. Comparative Political Studies, 37(5), pp. 590-610.

2

European political and economic

reconfiguration from the financial crisis:

Is Berlin the new European economic capital? Introduction The global financial crisis had a strong impact in Europe. The sovereign debt crisis is the consequence of internal problems within Europe, but the catalyst was the crisis in the housing sector in the US. The effects of the European crisis have been many; on one hand there has been a decline in GDP and an increase in the unemployment rate, while on the other hand, most European governments lost elections during the crisis. However, the effects are differentiated, because the unemployment rate in Greece and Spain has increased from 8% to 27%, while in Germany the unemployment rate fell from 8% to 5%. Moreover, while Greece has already had three different governments during the crisis, the German Chancellor, Angela Merkel, has won two elections during the crisis (2009 and 2013). During the sovereign debt crisis, Greece, Ireland, Portugal, Spain and Cyprus have been bailed out. To bailout, financial funds were created with contributions from member states of the EU. The contributions are based on the size of the economies, so that countries like Germany and France are the major contributors to the bailouts, and when bailouts are negotiated, these countries have more influence. On the other hand, the rating agencies have played an important role during the crisis, because these entities assess countries’ bonds, so that when they detect risks on public finances they lower their bond rating. Countries with low ratings on their bonds have higher risk premiums, as the case of the rescued countries, while countries with low risk premiums had better conditions during the crisis, this group includes Germany, Finland, Netherlands and Austria. Combining countries with larger contributions to bailouts and those with lower risk premium, highlights Germany, because that country is the largest contributor to bailout funds and its bond has the lowest risk of all 55

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countries in the EU. Therefore, the power of Germany during the financial crisis has increased significantly, which has allowed it to impose conditions on bailouts, in addition to the fact that its influence grew with the changes in the European economic governance. The locomotive of European integration has been the Franco-German axis that has conducted a long period of peace, besides most of the advances in economic integration have been proposed by Germany and France. Historically this axis has helped overcome many obstacles that European integration has had since the 50's. But France and Germany have different political and economic preferences, which have permeated the design of European institutions. In this sense, the ECB emerged by consensus among European politicians of the benefits of price stability, but preferences of a central bank focused on inflation have historically been those of Germany, while other countries have adopted these preferences due to the stability problems of the 70's and 80's. The text explores how it has reshaped the Franco-German axis and the ECB during the global financial crisis. In particular, we analyze whether European policy has been Germanized, due to the enormous influence Germany has acquired. Moreover, we studied the changes in the ECB during the crisis and whether there are variations in the initial purpose for which it was built. Reconfiguration of the Franco-German axis during sovereign debt crisis In the history of the European integration process the Franco-German axis has been a major driving force that has contributed significantly to achieving the EU objectives. An axis formed by two neighboring countries that were enemies for many years of war and that managed to forge a strong alliance between the two. In 1963, the signing of the Elysée Treaty between Germany and France was a turning point in history. Both countries transformed their rivalry into close cooperation to maintain peace and boost the European dream. French President Charles de Gaulle and German Chancellor Konrad Adenauer signed the treaty and formed an alliance that has remained for over 50 years. The relationship between the two countries has had its ups and downs. The strongest period of the axis was from 1974 to 1981, in which Valery Giscard d'Estaing, President of France and the German Chancellor Helmut Schmidt established what we consider as precedents of the euro, and they also proposed the institutionalization of the summits of heads of state and governments of member countries. Subsequently, the relationship and

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friendship between Francois Mitterrand and Helmut Kohl, facilitated the reunification of Germany and they were the architects of the Maastricht Treaty which established the EU. In 2001, informal consultations were established, known as the Blaesheim process, to boost the Paris-Berlin axis in the construction of the EU. Also Franco-German summits were held and attended by their respective ministers. To date, two meetings have been held. These efforts have been favorable to the European integration process. Despite some initial misunderstandings, Angela Merkel and Nicolas Sarkozy continued a close cooperation between the two countries. However, the financial crisis tipped the scales toward Germany, which previously existed in relation to the position of each of them within the EU. Germany, the largest economy in the euro area, became the leader in decision-making at the European level, France, by the weakness of its government, became an ally. The Franco-German axis joined to address the crisis, even when the balance of power between them was uneven. Germany exercises leadership or what some experts define as hegemony in Europe. The cooperation between the two countries has prevented the collapse of the currency area and the possible demise of the euro. So far, many experts predicted that the euro area would disappear completely in a short time. However, to date, despite everything that has happened the euro continues and the Franco-German axis too. In this scenario of crisis, Angela Merkel has played an important role. Since the beginning of the crisis the German Chancellor has publicly expressed not allow the euro area to disintegrate and linked the survival of the single currency for the EU as a whole. In 2012, Nicolas Sarkozy lost the French presidential elections and there was uncertainty about the permanence of the Franco-German axis. The fear was not unfounded because the position of French President François Hollande contrasts with Angela Merkel’s. For Merkel, the most important thing is austerity and to urge European governments to take strict measures to address the crisis. Steinberg and Molina (2012) argue that Germany is exercising leadership in the reform of the governance of the euro area almost alone and due to its strong position within the EU that country has been able to advance their interests above all other countries including France. In contrast to the position of Hollande, which highlights the need to develop ways to promote economic growth in Europe. During the sovereign debt crisis, the German position from the beginning was clear on the proposed strategy to follow. For Germany and some other members like Austria, this crisis was the result of a lack of discipline and excessive borrowing by irresponsible countries like Greece. Therefore, they believed that the solution is to impose greater fiscal discipline and make

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adjustment policies. This view leaves aside the failures of the European economic governance, limiting its liability with respect to the situation in some countries, especially in the periphery such as Portugal, Spain and Greece. Some European leaders decided to bail out indebted countries like Greece. The European Commission pressured them to reach an agreement on the Greek bailout plan with the IMF and euro area countries. Germany maintained a strong stance during the crisis and said it is essential that peripheral countries must implement austerity policies and structural reforms. This position has allowed Germany to extract concessions from European partners to bail out these countries. For Steinberg and Molina (2012) the only aspect in which the German government has changed its position is regarding the restructuring of Greek debt. Initially, Germany was aligned with the ECB in its opposition to accept a haircut and then advocated the involvement of the private sector in the Greek bailout. This triggered a panic in financial markets and the contagion spread to other countries. Germany returned to its initial position and argued that debt restructuring should be based on the principles of the IMF. The German Chancellor has been criticized, among others, for her hesitation to the crisis and for putting their national interests over those of the EU. France meanwhile lacks leadership and has been unable to act as the country had done on other occasions, a counterbalance to Germany. Reconfiguration of the European Central Bank after the sovereign debt crisis Background: Building the European Central Bank based on the Bundesbank The construction of the ECB goes back to the signing of the Maastricht Treaty, because the monetary union was established in three stages. In the third stage, a central bank that would manage monetary policy in the euro area would be required. The Eurosystem adopted the following characteristics of the Bundesbank: • Price stability (like the Bundesbank): the ECB's design was based on the premise that the main objective would be price stability. Some other central banks like the FED, in the US, have dual objectives such as price stability and full employment. However, construction of the ECB followed the German design of central banking, because price stability was established as the main objective, leaving secondary objectives and other economic variables of the EU, which in practice

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have little influence on decision making of the Governing Council of the ECB. • Independence from government: the ECB’s design was based on the German model of central bank independence from the government. The Bundesbank was built after the Second World War with the premise that decisions should be independent of the preferences of the current government, with the objective of a central bank with the freedom to create price stability in the economy and prevent episodes such as those registered in the German economy in intra-wars, where inflation reached levels greater than 6 digits. Sometime after World War II conflicts were generated between the German government and the Bundesbank, due to different preferences on monetary policy and exchange rate, however, in such situations the Bundesbank gained the support of the German society due to the latter’s fear of the hyperinflation recorded in intra-wars. • Federal Structure: The ECB, like the Bundesbank, was built on a federal structure. The Governing Council of the ECB has representatives elected by EU institutions and elected by national governments, while the Bundesbank has representatives from Landers and representatives of the German federal government. Finally, another important point which shows the German influence on the ECB is that the latter was established in Frankfurt, home of the Bundesbank. Heterodox decisions taken by the European Central Bank and the German resistance The ECB has implemented some heterodox measures during the financial crisis, which have been criticized by members of the Bundesbank and the German government. The fundamental idea behind German criticism is that the ECB must take decisions that only aim at price stability, because it was well established in the EU Treaty. However, given the magnitude of the crisis, the Governing Council of the ECB took the following heterodox measures: • Reductions in the benchmark interest rate: during the crisis the ECB has kept interest rates close to zero for a long period of time, such a situation had not presented itself before. In mid-2011 the Governing Council decided to raise the benchmark interest rate at German request. However, months later that central bank had to turn back the decision, because the economy of the euro area had unfavorable prospects, besides inflation expectations were below 2%.

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• Extended periods of open market operations: the ECB extended the LTROs in order to encourage lending in the banking system. • Support programs for financial markets: the ECB launched two bond purchase programs (BCPP1 and CBPP2) in 2010 and 2011, with the objective that the holders of such bonds have liquidity. On the other hand, the said central bank has intervened in the bond market through the SMP to generate liquidity. The above programs are heterodox measures that the ECB implemented, due to the depth of the financial crisis. The chief economist of the ECB, Juergen Starkand (German) member of its Governing Council, resigned from his position in the central bank in late 2011, because he did not agree with measures taken by the Governing Council. • A statement by the ECB President: Mario Draghi, ECB President, said in September 2012 that the central bank would be willing to buy the necessary amount of government bonds in the euro area on the secondary market in order to reduce risk premium in peripheral countries, due to the fact that high risk premiums reflected convertibility risks, and therefore comes within the ECB’s mandate. That statement had an effect on the sovereign debt market, because the risk premium of several peripheral countries of the euro area had been declining. Although the measure was not implemented, it has been debated (in Germany) if the ECB should stabilize the risk premium. Changes in the European Central Bank during the crisis of sovereign debt During the crisis in Europe, the average inflation in the euro area has been below 2%, and it was only in mid-2011 when it increased slightly, but the ECB raised its benchmark rate. With inflation under control, there have been the following changes in the ECB: • The ECB has become, de facto, a stabilizing element in the risk premium of the peripheral countries of the euro area. With the declaration of the President of the said central bank, Mario Draghi, in September 2012, the risk premium of the PIGS countries has been reduced considerably. The purchase of bonds in the secondary market has not become effective, however, one statement has had a stabilizing effect on the market. • Before the global financial crisis there was unanimity in the decisions of the Governing Council of the ECB, because only a simple majority is required for decisions, in addition the Executive Board has 6 votes of the Governing Council (18 votes), which means that the Board required 4 additional votes to get a majority, preventing

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others from forming majorities. In these terms, it is unlikely that a proposal (other than the Executive Committee) may reach a majority in the Governing Council, which reduces the incentive to dissent, because voting against a proposal by the Executive Committee is not likely to achieve a majority. The ECB President is responsible for explaining to the media the monetary policy decision taken by the Governing Council, while the other members do not declare to the press any opinion contrary to the one presented by the President. However, in September 2012, the ECB president announced the possibility of buying bonds in the secondary market with the support of a majority of the Governing Council, but the President of the Bundesbank, Jens Weidmann, voted against the measure, breaking the expected unanimous decision of the ECB, while another German at the meeting (Jörg Asmussen member of the Executive Board of the ECB) voted in favor. • The financial crisis has caused the ECB to take into account not only the economic fundamentals of the euro area, but also the peripheral countries, due to the spillover effects in the rest of the euro area. The fact that the President's statement about potential ECB bond purchases in the secondary market has stabilized the risk premium of the peripheral countries, shows the interest of the central bank for the externalities of peripheral countries over the entire euro area. Moreover, bailouts to peripheral countries show that the European institutions are interested in countries that represent a small proportion of the economy of the euro area (except Spain). Responses to the crisis the ECB and other European institutions have been criticized from Berlin and Frankfurt, because they are considered incompatible with the objectives of the ECB, because the bailouts would not be supported by the legal system of the EU and the effect on moral hazard of the measures. Conclusions The international financial crisis and the austerity policies (driven by the Troika) had two main effects in the EU: • The Franco-German axis has been reconfigured, because Germany has the economic/political leadership. Chancellor Angela Merkel has led the orchestra in economic decisions that have been imposed within the EU. Merkel's strength can be explained because she governs the country that has contributed most to the bailouts that have taken place

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to date, besides Germany is a country with the lowest risk premium in the EU. On the other hand, Chancellor Angela Merkel was the only prime minister of a large EU country that has been re-elected in crisis, 2009 and again in 2013. While in the case of the UK, France, Italy and Spain there have been changes of government. Economic power achieved by Germany in the EU is unprecedented since the Second World War, because for the most part, in Berlin, not necessarily in Brussels, the bailouts are decided. • The ECB has been reconfigured in a scenario not seen before, because they had to take exceptional measures. However, this was possible because inflation in the euro area had been stable, and in periods when it had passed this limit, as measured in 2011, the response had been a rise in the reference rate, the usual from a standpoint of Bundesbank monetary orthodoxy. Exceptional measures have been criticized from Frankfurt, because the former ECB chief economist Juergen Stark, resigned because he was against some of the measures taken in the Governing Council, while the Bundesbank President Jens Weidmann, voted against the proposal for a possible buying of bonds in the secondary market, breaking the supposed consensus of the Governing Council of the ECB. The reconfiguration of the ECB in crisis is due to the poor economic performance of peripheral countries. At this point it is important to note that Berlin has yielded the reconfiguration of the ECB, because they were seen as exceptional measures, in addition price stability has never been at risk. However, the Bundesbank orthodoxy has been felt at the ECB, with episodes such as Stark and Weidmann, besides historically the German government and the Bundesbank have not had the same preferences. Müller (2013) notes that Kissinger’s question in the seventies, where he highlighted the fact that Europe did not have a phone number, Ulrich Beck (2012) responds to that question saying that the telephone number in Europe is located in Berlin and major powers like the US, China and even in Europe itself have accepted this fact informally. This idea that Berlin is informally the political capital of Europe, shows the enormous economic and political power that Germany has acquired in the last two decades and increased with the financial and sovereign debt crisis, due to the vulnerability of European countries. Moreover, since the birth of the ECB it seems that the phone number in the European monetary area is located in Frankfurt, and not just because the seat of the central bank was established in that city, but because ECB’s design was based on the Bundesbank and also that despite the crisis, price stability has been maintained (fundamental premise of the Bundesbank).

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References Beck, U., 2012. Una Europa alemana. Buenos Aires: Paidós. Blejer, M. I., Leone, A. M., Rabanal, P., & Schwartz, G., 2002. El objetivo de inflación en el contexto de los programas de ajuste apoyados por el FMI. Boletín, 48(1), pp. 16-29. IMF, 2012. The Liberalisation and Management of Capital Flows: An Institutional View. Washington: International Monetary Fund. Muller, E., 2013. Europa, capital Berlín. El País, [online] 3 September. Available at: [Accessed on 8 September 2013]. Sanahuja, J. A., 2000. Ajuste, pobreza y desigualdad en la era de la globalización. In: M. Aguirre, T. Filesi & M. González, eds., Globalización y sistema internacional. Barcelona: Icaria, pp. 37-67. Steinberg, F., & Molina Álvarez de Cienfuegos, I., 2012. El Nuevo gobierno del euro: ideas alemanas, intereses divergentes e instituciones comunes. Revista de Economía Mundial, 30, pp. 59-81. Stephanou, C., 2011. The Banking System in Cyprus: Time to Rethink the Business Model?. Cyprus Economic Policy Review, 5(2), pp.123-130. Williamson, J., 2009. Short History of the Washington Consensus. Law & Business Review of the Americas, 15 (7), pp. 7-23.

3

Testing regional leadership in central banks: The case of the European Central Bank during financial crises

Introduction The global financial crisis and the European sovereign debt crisis tested out the regional leadership of the ECB, because of its unconventional tools used to reduce the effects of the crisis. The FED assumed the global leadership during the crisis because it promoted international monetary cooperation agreements and its monetary policy was followed by other central banks. As the states, central banks can achieve regional or global leadership because they can influence decisions taken by other central banks. During the crisis, the leaders are very important because they drive global or regional efforts to mitigate impacts on the countries. Regional leadership has been defined, in the context of states, as the ability of a leader to make the followers follow its proposals (Malamud, 2011). In the case of the central banks, we apply the same definition, that a proposal of a central bank leader is followed by other central banks. The aim of the paper is to analyze whether the ECB was a regional leader during the crisis. According to Zwartjes, Van Langenhove, Kingah, & Maes (2012), there are three elements that determine the regional leadership of central banks: willingness, capacity and acceptance. We quantified the three elements to determine if the ECB was a regional leader in Europe. Conceptual framework: Global and regional leadership in the context of central banks Same as with the states, the central banks can achieve regional leadership, although there are some differences. The regional leadership of the US, some European countries, Turkey, Japan, China, India and Brazil has been well doc65

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umented (Dent, 2010; Brzezinski & Mearsheimer, 2005; Barysch, 2010; Nolte, 2007). Moreover, the FED, the ECB, the BoE and the BoJ have the most used currencies, hence these central banks practice some degree of leadership. Malamud defined the concepts of hegemony and leadership in the following way: Hegemony is understood as the capacity of a powerful state (hegemon) to dictate policies to other states in its vicinity, while leadership is defined as the capacity to engage subordinate states so that they adopt the goals of the leading state as their own (2011: p. 4). The concept of regional leadership is made up by a leader, one or more followers and a leader's policies that are followed by the followers of a region. The concept of regional leadership can be extended to global leadership; in this case there is a central bank that influences several followers of various regions of the world. Zwartjes, Van Langenhove, Kingah & Maes (2012) argued that there were three determinants to achieve regional leadership: willingness, capacity and acceptance. Considering Malamud’s definition of regional leadership and the three determinants suggested by Zwartjes, Van Langenhove, Kingah & Maes, we highlight the differences between the regional leadership of the states and the central banks: 1) The central banks are part of the states, or in the case of Monetary Unions, they are part of the supranational states. In this sense, the regional leadership of central banks is always bounded by the decisions taken by governments. However, there are often technical decisions that rely on the central banks, political and economic independence has been granted to central banks due to the benefits of price stability (Alesina & Summers, 1993; Berger, De Haan & Eijffinger, 2001). 2) The central banks’ objectives are better defined than the state’s objectives. For example, some central banks are responsible for price stability, while others have added different goals such as full employment and financial stability. The states can have several objectives, ranging from the economic to the social area. In this sense, the regional leadership is more limited for central banks. 3) Governments and central banks are composed of working groups. Governments are constituted by Ministries of State, while in the central banks there are different types of committees. The difference is that in the case of governments, the prime ministers or the Presidents can achieve leadership more fully because they are elected by the vote of the citizens, whereas in the case of central banks, decisions must be adopted by the committee, where each member has the same weight. In addition, members of the committees of the central

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banks are elected by the Parliament at the request of the President or the prime minister. 4) In the supranational central banks, as the ECB, the regional leadership is restricted by the interests of national governments with the largest economies, such as the German government, or supranational institutions as the European Commission, the Euro group and the Council. 5) The way to achieve regional leadership among central banks is more technical because most times regional leadership is achieved through measures implemented to provide liquidity to the financial system or through agreements to improve monetary cooperation among central banks. 6) The governments achieve regional leadership through bilateral agreements with other governments, or multilateral agreements in IOs, as the UN, the OECD, international forums as the G7, G10 and G20, while CBs achieve RL through bilateral agreements with other central banks, or within IOs, such as the IMF, the BIS or the WB. 7) The regional leadership of a central bank is linked to the strength of its currency. When a currency is strong or "anchor currency" (Alesina & Barro (2001), central banks are more likely to achieve regional leadership. 8) Cohen (2004) used the concept of ‘currency pyramid’ to show that there are few strong currencies. Starting from the concept of ‘currency pyramid’, it is feasible that there are few central banks with regional leadership and global leadership because there are few “anchor currencies”. Below we analyze each of the three elements that determine regional leadership applied to the context of central banks. Willingness The willingness of regional leadership in central banks can be achieved through the speeches of the Presidents of the central banks, where specific actions or measures that can have regional or global scope are announced. Moreover, the willingness of regional leadership is achieved over time. For example, the regional leadership of the FED has a history in which its Presidents, through their speeches, have created the conditions that identify the FED as a global and a regional leader. Communication in the central banks is important because the decisions about monetary policy have immediate impact on the markets, hence communication policies are implemented at the central banks, in which the Presi-

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dent of the central bank gives a press conference after the monetary policy decision has been taken. Furthermore, as part of its communication policy, some central banks publish their minutes with a lag period. Capacity A government’s capacity is measured through the influence they have on other governments, which can range from the military capability to the economic capacity. In the case of central banks, the capacity to achieve regional leadership lies in all the tools they possess to influence other central banks. Acceptance Acceptance of the regional leadership means that others follow proposals of the leaders. In the case of central banks, we considered that the acceptance of regional leadership can be considered as the linkage among currencies, where there are few “anchor” currencies (leaders) and many “weak” currencies (followers). The linkage of currencies shows the degree of relationship of the currencies of the central banks, because when currencies are linked to an “anchor currency”, regional leadership is accepted. An extreme case is when a country uses the currency of another country. An example of this is what is known as “dollarization” or “Eurozation”. The European Central Bank during the crisis To analyze the decisions taken by the ECB during the global financial crisis, we considered two periods: The first period is from 2007 to 2009, and the second period is from 2010 to 2012. We used those periods because during the European sovereign debt crisis, which began in late 2009, the ECB took unusual measures. Moreover, the measures taken by the ECB are compared to the FED, in order to analyze their impact on the regional and global context. There are differences between the ECB and the FED that are related to the way they were structured. While the ECB has central bankers elected by the national and supra-national institutions, the FED has central bankers elected by national authorities, and central bankers from the districts in which the US is divided. The FED aims for a high level of employment and low inflation, while the ECB's target is price stability, which is set to 2%. The FED does not have a quantitative target in either of the two variables.

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First Period: 2007-2009 In mid-2007, risk increased in the financial markets due to the problems of sub-prime mortgages. The ECB, as other central banks of the world, began to increase liquidity in the financial system. In August, 2007, the ECB conducted a larger number of liquidity adjustment operations, executed several fine-tuning operations (Ayuso and Malo, 2011). In December, 2007, the FED launched the TAF since the long-term credit was limited by the financial crisis that had begun in 2007. The TAF was used to provide liquidity to the financial market through 28-day loans to financial institutions, which was subsequently extended to 84 days (FED, 2007). In March, 2008, the FED launched the PDCF in order to encourage short-term liquidity for the "primary dealers" who are "brokers" for the FED. Through the PDCF, the FED gave short-term loans to the "primary dealers", because the credit was not available in the financial market at that time. Moreover, the FED triggered a mechanism for exchanging assets with financial institutions, whereby the FED swapped assets that could be used as collateral to obtain liquidity (US Treasury) for non-eligible assets. In December, 2007, the ECB, the FED and other central banks launched the "Dollar Swap Facility" program, which established a mechanism to ensure the provision of foreign currency among central banks. The aim was to generate dollar liquidity in financial institutions. Table 3.1 Dollar swap announcements Central Bank FED FED FED FED FED FED FED FED FED FED FED FED FED FED

Date 12-Dec-07 11-Mar-08 2-May-08 30-Jul-08 18-Sep-08 18-Sep-08 18-Sep-08 24-Sep-08 24-Sep-08 26-Sep-08 29-Sep-08 29-Sep-08 29-Sep-08 29-Sep-08

Central Bank ECB ECB ECB ECB ECB BoJ BoC RBA SRB ECB ECB BoJ DNB BoC

Billions 20 30 50 55 110 60 10 10 10 120 240 120 15 30

Central Bank SNB SNB SNB SNB SNB BoE

Billions 4 6 12 8 27 40

DNB NB SNB SNB BoE SRB NB

5 5 30 60 80 30 15

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FED FED FED FED FED FED FED

29-Sep-08 13-Oct-08 13-Oct-08 14-Oct-08 28-Oct-08 28-Oct-08 29-Oct-08

RBA ECB BoE BoJ RBNZ Korea Brazil

30 NE NE NE 15 30 30

SNB

Singapore Mexico

NE

30 30

Source: Goldberg, Kennedy, & Miu (2010)

Table 3.1 shows the swaps that were established between the FED and the various central banks involved. The first swap was between the FED and the ECB ($20 billion USD) and the SNB ($4 billion USD); the objective was to provide dollars to the euro area and Switzerland. The following swaps were established among the FED, the ECB and the SNB involving similar amounts of money and for the same purpose (March 2008-July 2008). On September 18, 2008, after the bankruptcy of Lehman Brothers, the FED implemented a swap that included the mentioned central banks, but also the BoJ, the BoE and the BoC, with a total value of $247 billion USD. In the same month, another three swaps were conducted, including three Nordic CBs. Their combined value was around $800 billion (US dollars). The bankruptcy of Lehman Brothers caused the CBs to take exceptional measures, because the global financial crisis was spreading to the economy. The ECB changed its tenders, LTRO and MRO, from a variable rate to a fixed rate (Ayuso and Malo, 2011), in order to generate confidence in the financial market, in addition to granting the entire requested demand. Furthermore, in May 2009 the average maturity of monetary policy operations was extended to 12 months. In October, 2008, there was a coordinated monetary policy among the FED, the ECB, the BoC, the BoE, the Riksbank and the SNB. These central banks decreased 50 basis points their target interest rates (FED, 2008), additionally the BoJ supported the measure. In May, 2009, the ECB launched the CBPP1, which consisted of the purchase of mortgage bonds in order to provide liquidity and stimulate the recovery of the sector. The amount of the purchases was €60 billion (ECB, 2009). With the bankruptcy of Lehman Brothers, the FED had lowered its target interest rate near to zero and therefore implemented a program called QE. The program consisted of the purchase of debt, such as MBS, consumer loans, Treasury bills, bonds and notes, in order to generate liquidity in the financial market. The first QE1 was launched in November 2008 with a total

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value of $700 billion, of which $600 billion related to MBS and the rest was destined to other debts. In late March, 2009, the FED launched the second round of QE1 for a total of $1,150 billion, of which $750 billion were for the purchase of MBS; $100 billion for the "Fannie and Freddie debt" and $300 billion for longer term treasuries. Second Period: 2010-2012 The second period began with the European sovereign debt crisis, specifically when the Greek bailout was necessary because of the insolvency of the Greek government. The ECB launched the SMP, in mid-2010 (Gros, Alcidi, & Giovannini, 2012), an unconventional measure, which involved the purchase of Greek bonds on the secondary market in order to reduce the price differential between the Greek and the German bonds, and thus prevent the spread of the Greek crisis to other peripheral economies of the euro area. The ECB sterilized Greek bond purchases through Open Market Operations, so that the bank balance remained the same. In August, 2011, the ECB launched a second package to purchase sovereign debt on the secondary market in countries with a high-risk premium; the total amount of this second package was €50 billion. In October, 2011, the ECB launched CBPP2 with the purchase of mortgage bonds with a value of €40 billion (ECB, 2011A). In December, 2011, the ECB implemented a 36-month LTRO with the option of repayment after one year (ECB, 2011B) and in total there were 500 banks that demanded €490 billion, while in February, 2012, 800 banks received €530 billion (Gros, Alcidi & Giovanni, 2012). In November, 2011, the FED launched its QE2 by buying $600 billion in Treasury securities in order to improve the prospects of the US economy. Finally, in September, 2012, the FED launched QE3 with the purchase of $40 billion in MBS and also announced that its target interest rate would remain near zero until 2015 and would keep the QEs until there was an improvement in job creation. Leadership in the crisis: European Central Bank VS the Federal Reserve Regarding the management of the reference interest rate, the behavior of the FED and the ECB was entirely different. The FED took a path of steady decline of its reference interest rate from late 2006 until late 2008, because the said rate went from 5.25 to almost zero over a period of two years with reductions of up to 75 basis points three times in 2008. The ECB lowered its reference interest rate later than the FED because in 2007 the reference interest rate raised, and then in late 2007 it began a steady decline until May,

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2009. During this period, the reference interest rate fell from 4.25% to 1%. A decrease of 75 basis points happened only once. In April and July, 2011, the ECB raised its reference interest rate again, and then the ECB lowered the reference interest rate at the end of 2011 and in mid-2012. The BoE raised its reference interest rate in 2007. However, since December of that year, there had been a reduction that lasted until March 2009, keeping it near zero until now (0.5) (Table 3.2). The Riksbank had a similar behavior to the ECB. Table 3.2 Reference interest rate: The Federal Reserve, European Central FED RIR Year date 2008 Dec. 16 0-0.25 1.00 Oct. 29 1.50 Oct. 8 Apr. 30 2.00 Mar. 18 2.25 3.00 Jan. 30 3.50 Jan. 22 2007 Dec. 11 4.25 Oct. 31 4.50 4.75 Sep. 18 5.25 2006 Jun. 29

ECB Year date 2012 Jul. 11 2011 Dec. 14 Nov. 9 Jul. 13 Apr. 13 2009 May. 13 Apr. 8 Mar. 11 Jan. 21 2008 Dec. 10 Nov. 12 Oct. 15 Oct. 9 Oct. 8 Jul. 9 2007 Jun. 13 Mar. 14 2006 Dec. 13

Sources: FED, ECB, BoE and Riksbank

RIR 0.75 1 1.25 1.5 1.25 1 1.25 1.5 2 2.5 3.25 3.75 3.75 3.75 4.25 4 3.75 3.5

BoE Year date 2009 Mar. 5 Feb. 5 Jan .8 2008 Dec. 4 Nov. 6 Oct. 8 Apr. 10 Feb. 7 2007 Dec. 6 Jul. 5 May. 10 Jan. 11 2006 Nov. 9

RIR 0.5 1 1.5 2 3 4.5 5 5.25 5.5 5.75 5.5 5.25 5

Riksbank Year date 2012 Dec. 19 Sep. 12 Feb. 22 2011 Dec. 21 Jul. 6 Abr. 27 Feb. 16 2010 Dec. 22 Oct. 27 Sep. 8 Jul. 7 2009 Jul.8 Abr. 22 Feb. 18 2008 Dec. 10 Oct .29 Oct. 15 Sep. 10 Jul. 9 Feb. 20 2007 Oct. 31 Sep. 12 Jun. 27 Feb. 21 2006 Dec. 20

RIR 1 1.25 1.5 1.75 2 1.75 1.5 1.25 1 0.75 0.5 0.25 0.5 1 2 3.75 4.25 4.75 4.5 4.25 4 3.75 3.5 3.25 3

The behavior of the FED has been followed by the BoE and later by the ECB

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and the Riksbank. The FED had cut its reference interest rate near zero, while the other CBs had finished doing the same, even the ECB (like the Riksbank) raised its reference interest rate in 2011, but decreased it later. When the reference interest rate was close to zero (December 2008), the FED implemented its first QE1 in late 2008 and early 2009, while the BoE and the Riksbank launched their QEs in mid-2009, but the amounts of the FED were higher than the BoE and the Riksbank, then both CBs have maintained that schema. The ECB did not implement a QE, because the CBPP1, CBPP2 and SMP were sterilized, so that the effects on the economy were different. Gros, Alcidi and Giovanni (2012) showed that CBPP1, CBPP2 and SMP had very limited effect in relation to the QEs implemented by the FED and the BoE. The FED had the regional leadership and global leadership because it was the central actor to the "Dollar Swap Facility" in December 2007, where several central banks used the program as insurance in case their banks required dollar liquidity. In the management of the reference interest rate, the FED had regional and global leadership, because it was the first central bank to reduce its reference interest rate, when other central banks, like the ECB, the BoE and the Riksbank, increased their reference interest rates. Furthermore, the FED had the flexibility to lower its reference interest rate by 75 basis points three times. When the reference interest rate was close to zero, hence the effects of monetary policy were very limited, the FED was the first to implement the QE, and then other CBs as the BoE and the Riksbank did the same. Empirical analysis of the regional leadership Data Press conference of the President of the European Central Bank The data came from the press conference delivered by the President and Vice-President of the ECB after the monetary policy decision on the Governing Council of the ECB was made. These press conferences are published by the ECB and also include rounds of questions and answers. The reporting period is from 2002 to the press conference of April 4th, 2013. We excluded the press conferences whose purpose was other than explaining the monetary policy decision.

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Currencies in international reserves The most used currencies as international reserves come from the Currency Composition of Official Foreign Exchange Reserves of the IMF. The data are from 2002 to 2012, it also includes quarterly data from 2007 to the third quarter of 2012. The currencies included are: the US dollar, the euro, the British pound, the Japanese yen and the Swiss franc. De facto regimes of exchange rate The exchange rate regimes of European currencies came from annual reports (2003, 2004, 2005, 2006, 2008 and 2012) on "De Facto Classification of Exchange Rate Regimes and Monetary Policy Framework and Exchange Arrangements and Exchange Restrictions” of the IMF. For the missing years we used the websites of CBs. We used the de facto exchange rates because countries often claim to have an exchange rate, but in reality they are using another. We included the European countries that are part of the Council of Europe (47 countries). The period of analysis is from 2002 to 2012. Methodology Willingness To measure the willingness of the ECB to exercise regional leadership, we analyzed the President's press conferences. We counted the times that the following groups of words related to the regional leadership were mentioned during each conference: Group 1: ‘global’, ‘international’ and ‘world’ Group 2: ‘governance’, ‘cooperation’ and ‘crisis’ Group 3: ‘leader’ and ‘regional’ The first group of words is related to global actions that the President of the ECB would mention; the second group of words are collective actions that must be implemented in times of financial crisis. Finally, the last group of words correspond to those related to the leadership of the ECB. The words of each of the three groups were only included if they were related to the specified context. We created the following indicator: Xi = wi /n

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Where: Xi is the average number of times the word i is mentioned per press conference in a year, while wi are the times the word i is mentioned in a year, and n is the number of press conferences per year. Additionally, another indicator was constructed: Yi = zi / n

Where Yi is the average number of times the word i is mentioned per press conference at the period of each of the presidents of the ECB, while zi are the times the word i is mentioned in the mandate of the ECB's Presidents and n are the press conferences by mandate of the ECB’s Presidents. As the above indicators increase, the chairman of the ECB has the willingness to exercise regional leadership. Capacity To measure the capacity of regional leadership, the percentage of international reserves in the currencies maintained by central banks was used. As a central bank has a currency that is used as international reserves, its capacity to exercise RL increases. Acceptance To measure the level of acceptance of the regional leadership of the ECB, we built an indicator that shows the acceptance of the euro in Europe. We established a relationship between the exchange rate of the European countries and the euro. The following table (Table 3.3) shows the value of the relationship between European countries and the euro, which depend on the exchange rate. The relationship is stronger when the euro is used as a national currency (there are 19 current members of the euro area), so that the value of such a relationship is higher. If countries do not use the euro, but their currencies are linked to the euro, the value takes low but positive values. When a European country has a flexible exchange rate, or is under an IMF program or has tied its currency to more than one currency, the value of the relationship is zero, whereas if the currency has a relationship with any other currency, the value is negative. If a European country uses the currency of another country (dollarization), it reaches the minimum value.

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Table 3.3 Values of exchange rate regimes Exchange rate regime Euro area Eurorization with monetary agreements Eurorization (unilateral) Currency board to the euro (in the EU) Currency board to the euro (not in the EU) Exchange rate mechanism II Euro as a reference currency, (in the EU)

Value

4.5 4

Exchange rate regime Euro as a reference currency, (not in the EU) Free floating regime + inflation targeting IMF program

3.5

More than 1 anchor

5

3 2 1.5

Value 1 0 0 0

Anchor to US dollar Currency board to US dollar

-1 -3

Dollarization

-4

Sources: IMF and websites of central banks.

The idea of putting positive and negative values is because if one of the central banks (in Europe) has a strong link with the euro (through the exchange rate), the RL of the ECB increases, while if the link is with another currency, the regional leadership of the ECB decreases. If there is no link, as when the exchange rate is flexible, the regional leadership of the ECB neither increases nor decreases. Starting from identifying the type of link between the euro and the 47 European countries, the corresponding values were assigned from 2002 to 2012. The result was a matrix of 47 * 11 with the exchange rate relations between the CBs and the ECB. Parting from the above matrix, we created the following acceptance indicator of regional leadership: Wt = ∑ in (X it * Yit m Where Wt is the acceptance indicator of regional leadership of the ECB in Europe. As the indicator is higher, the acceptance of the ECB (as regional leader) is higher, whereas if the value is lower, the acceptance of the ECB (as regional leader) is lower. The indicator can take the following values: -1 ≤ wt ≤ 1

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When Wt is close to -1, the ECB does not have acceptance of regional leadership in Europe, whereas when Wt is close to 1, the ECB has full acceptance of regional leadership in Europe. Intermediate values mean different degrees of acceptance of regional leadership. Xi,t are the 12 columns of the matrix of exchange rate relationships of each of the 47 countries in the ECB, while Yi,t is the weight given to each of the countries according to the size of the population, i.e., the largest European countries receive greater weight than smaller countries. m is a fixed value, which is equal to the number of European countries (47) times the maximum value that a relationship can take for each year (5), where m = 235. The result is an indicator that covers the period 2002-2012, and shows the variation of the acceptance of the ECB (as regional leader). Empirical analysis Willingness of the European Central Bank to exercise regional leadership The indicator of the willingness to exercise regional leadership shows that the first group of words (‘global’, ‘international’, and ‘world’) were not more frequently pronounced since the beginning of the crisis. Figure 3.1 shows that the same trend is maintained at the repetition of those words since 2006 and only changed in 2012 when there was a systematic reduction. It would mean that the mention of the words of group 1 by the President of the ECB would be a sign for an interest in global issues and somehow to express a willingness to exercise regional leadership.

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Figure 3.1 Words (group 1) mentioned per press conference

Source: Own elaboration with data of the ECB.

In the second group of words, there is a significant increase of the word ‘governance’ and ‘crisis’, from 2009 in the former case, and 2010 in the last case (Figure 3.2). It is understood that the word ‘crisis’ has been recently more pronounced by the President of the ECB, due to the implications of the crisis on the European economy. Nevertheless, from 2012 there is a decrease in the times the word ‘crisis’ was mentioned despite the intensity of the crisis. The word ‘governance’ began to be mentioned more frequently a year after the global financial crisis broke out, but as with the word ‘crisis’, there was a decrease in the number of times it was mentioned in 2012; however, in 2013 it was used again. The word ‘cooperation’, which denotes an element to solve the financial crisis has been increasingly mentioned in the press conferences since 2008. The results of the second group of words show a general increase in the willingness of the ECB to exercise RL since 2008, but from 2011 there is a downward trend.

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Figure 3.2 Words (group 2) mentioned per press conference

Source: Own elaboration with data of the ECB

Figure 3.3 shows that there was an increase in the repetition of the third group of words from 2011. Particularly since that year, the word ‘leader’ increasingly began to be mentioned, which shows an increase in the willingness of the ECB's president to exercise regional leadership.

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Figure 3.3 Words (group 3) mentioned per press conference

Source: Own elaboration with data of the ECB. Figure 3.4 shows how many times by press conference that presidents of the ECB mentioned the words of the three groups during their terms. Trichet mentioned the words of group 1 (‘world’, ‘global’, ‘international’) more regularly. Draghi had also been at the ECB during a part of the crisis, but he did not mention those words too frequently. Draghi has mentioned more regularly the terms ‘crisis’ and ‘governance’ (second group of words) by press conference, which shows that the current President has been willing to exercise regional leadership. Of the third group of words, the word ‘leader’ has been mentioned more regularly by Draghi, which reinforces the idea that the current President of the ECB has had a greater willingness to exercise regional leadership due to the circumstances of the sovereign debt crisis.

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Figure 3.4 Words mentioned per press conference by the Presidents of the European Central Bank

Source: Own elaboration with data of the ECB

Capacity of the European Central Bank to exercise regional leadership To measure the capacity to exercise regional leadership, the percentage of international reserves that are held by the central banks was used. At a European level, the central banks with the strongest currencies are the ECB, the BoE and the SNB. Figure 3.5 shows the percentage use of the main world currencies as international reserves. The US dollar remained the most used currency by the central banks, however, since the global financial crisis, its percentage use decreased from 64.13% (2007) to 61.81% (2012). The euro, being the second most used currency in the world, also decreased from 26.28% (2007) to 24.14% (2012) due to the global financial crisis. The use of other currencies as international reserves is marginal; in 2012, the figure shows a use of the Japanese yen of 4.11%, of the British pound of 4.09%, of the Swiss franc of 0.34% and of other currencies of 5.52%.

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Figure 3.5 Percentage use of the main world currencies as international reserves

Source: IMF

Figure 3.6 shows the percentage use of the euro as an international reserve quarterly. At the beginning of the crisis, there was a rising trend in the use of the euro rising from 25.17% in the first quarter of 2007 to reach 27.98% in the third quarter of 2009, but then there was a decrease in the use as an international reserve currency, because its use went from 27.98% in the third quarter of 2009 to 24.14% in the third quarter of 2012. The decline of the use of the euro as an international reserve coincided with the period of the European sovereign debt crisis, which decreased the capacity of the ECB to exercise regional leadership. The sovereign-debt crisis in Europe weakened the euro as an international currency, which caused the regional leadership of the ECB to fall marginally, though other major European currencies, such as the British pound and the Swiss franc, were not used in a higher percentage.  

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Figure 3.6 Percentage use of euro as international reserves around the world

Source: IMF

Acceptance of the European Central Bank as a regional leader Figure 3.7 shows the indicator of acceptance of the ECB as a regional leader. The acceptance of RL of the ECB has been on the rise from 2002, the year of the launch of the euro, until 2010. In 2011, the acceptance of regional leader of the ECB decreased due to the European sovereign debt crisis. In 2012, it remained the same as in 2011. The acceptance of regional leadership of the ECB has been increasing, because of the confidence it had generated since the launch the euro and the ECB among international actors. The global financial crisis did not decrease the acceptance of the ECB, it was the European sovereign debt crisis that reduced the ECB's acceptance as a leader in Europe. The European sovereign debt crisis showed the weakness of the euro area; by having a single monetary policy and several fiscal policies, and the immense effect it had on the euro area that a small country, like Greece, had a high risk premium. The above circumstances weakened the regional leadership of the ECB in Europe, although this decrease did not generate greater acceptance in the regional leadership of other CBs in Europe. It would be

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necessary to wait a few years to see if some European countries prefer to peg their currencies to other European currencies, such as the British pound and the Swiss franc. Figure 3.7 Indicator of acceptance of the regional leadership of the European Central Bank

Sources: Own elaboration with data of the IMF and websites of the CBs

Global analysis Table 3.4 shows the evolution of the three elements of regional leadership of the ECB from 2002 to 2012. Before the global financial crisis (2002-2007) there was no change in the willingness of the President of the ECB to exercise regional leadership, however, it increased its capacity and acceptance because of the prestige that the euro was acquiring. During the global financial crisis (2008-2009), the willingness of the ECB to exercise regional leadership remained unchanged and continued increasing its capacity and acceptance. The European sovereign debt crisis (2010-2012) caused changes in the three elements of regional leadership. During that period, the presidents of the ECB, Trichet and Draghi, increased the willingness of the central bank to

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exercise the regional leadership in Europe, however, given the magnitude of the crisis, the euro was less used as international reserves, and less central banks pegged their currencies to the euro, resulting in the decrease of the capacity and acceptance of the regional leadership of the ECB. Table 3.4 Global analysis of regional leadership of the European Central Bank Period 2002-2006 2007-2009 2010-2012

Crisis Before global financial crisis During global financial crisis During European sovereign debt crisis

Willingness no changes no changes increased

Capacity increased increased decreased

Acceptance increased increased decreased

Sources: Own elaboration with data of the IMF and websites of the central banks

Conclusions The global financial crisis and the European sovereign debt crisis were the first major challenges of the ECB. In such crises, the ECB implemented unconventional measures that tested its ability to generate stability in the euro area. Since the launch of the euro, it became the second currency of most importance in the world, because of the economic size of the euro area countries, the prestige of the "Bundesbank" and the German mark. It was expected that the ECB would have regional leadership in Europe, due to its independence from national and supranational authorities. During the European sovereign debt crisis, the ECB was overtaken by the challenges, because it did not have all the necessary tools to address such challenges. On the other hand, the FED achieved global leadership during the global financial crisis, because the said central bank boosted several international agreements to address the effects of the financial and economic crisis. The FED systematically reduced its reference interest rate from late 2006 until late 2008 (which was very close to zero), and then implemented the QE program to provide greater liquidity to the financial system. Some other central banks of the world, such as the BoE and the Riksbank followed the behavior of the FED, although in the case of the BoE, it first raised the reference interest rate in 2007, but later decreased to almost zero, while the Riksbank raised its reference interest rate in 2011 but then declined it in 2012. The ECB did not apply the QE program, and sterilized the liquidity provi-

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sion programs, so the result was different to other programs implemented by central banks. The aim of this paper was to quantify the regional leadership of the ECB before and during the global financial crisis and the European sovereign debt crisis. Each of the three elements of regional leadership were quantified for the ECB, through indicators that show its influence in several central banks of Europe. The results show that the sovereign debt crisis increased the willingness of the Presidents of the ECB to exercise regional leadership due to the need for the ECB to mitigate the effects of the crisis, and that in September 2012, President Mario Draghi said that the ECB would buy unlimited amounts in the secondary market of the sovereign debt. The unlimited purchase of sovereign debt has not been activated yet, however, the risk premium has fallen in several peripheral countries. The capacity to exercise regional leadership by the ECB was on the rise before the European sovereign debt crisis because the euro began to be used in international reserves by several central banks. The US dollar remained the currency most widely used in international reserves, however, the euro was established as the second most used currency; at European level, it was established as the leading currency in the region. The European sovereign debt crisis decreased the use of the euro in international reserves of the central banks, which decreased the ECB's capacity to exercise regional leadership, however, at a European level, that central bank remained the regional leader but with less capacity. The acceptance of the ECB as a regional leader in Europe was on the rise since the launch of the euro until 2010, from 2011 it decreased. We showed that the acceptance of the euro in European countries declined in 2011, coinciding with the European sovereign debt crisis. The effects of the global financial crisis in Europe decreased confidence in the euro among financial agents and among some central banks. To the extent that the crisis will end soon, the confidence in the euro will return to the peak levels of 2010. However, internationally the ECB is far from being considered a global leader, because the level of acceptance of the US dollar occurs in several regions of the world, while the euro is focused mainly on Europe and to a lesser extent on Africa. The regional leadership of the ECB during the global financial crisis and the European sovereign debt crisis was differentiated, because while in the global financial crisis the reaction was slow (and in partnership with other central banks measures) the measures were taken after the FED, in the European sovereign debt crisis, the reaction of the ECB was more effective in reducing the risk premium in several peripheral countries. In addition, the

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current president has had more willingness to exercise regional leadership in press conferences. Nevertheless, the capacity and the acceptance of the ECB declined in recent years because of doubts that have arisen due to the situation of some countries such as Greece, Spain and Cyprus. References Alesina, A., & Barro, R. J., 2001. Dollarization. The American Economic Review, 91(2), pp. 381-385. Alesina, A., & Summers, L. H., 1993. Central bank independence and macroeconomic performance: some comparative evidence. Journal of Money, Credit and Banking, 25(2), pp. 151-162. Ayuso, J., & J. L. Malo, 2011. El papel de los bancos centrales durante la crisis financiera: lecciones para el futuro. Papeles de la Fundación de Estudios Financieros, 42, pp. 49-64. Barysch, K., 2010. Can Turkey combine EU accession and regional leadership?. Policy Brief, 4. Berger, H., De Haan, J., & Eijffinger, S. C., 2001. Central bank independence: an update of theory and evidence. Journal of Economic surveys, 15(1), pp. 3-40. Brzezinski, Z., & Mearsheimer, J. J., 2004. Clash of the Titans. Foreign Policy, 146(1), pp. 46-49. Cohen, B. J., 2004. The future of money. Princeton: Princeton University Press. Dent, C. M., 2010. China, Japan and regional leadership in East Asia. Cheltenham: Edward Elgar Publishing. ECB, 2009. Purchase programme for covered bonds [Press Release]4 June 2009. Available at: http://www.ecb.int/press/pr/date/2009/html/pr090604_1. en.html [Accessed 26 March 2013]. ECB, 2011A. ECB announces details of its new covered bond purchase programme (CBPP2) [Press Release] 3 November 2011. Available at: http://www.ecb. int/press/pr/date/2011/html/pr111103_1.en.html [Accessed 26 March 2013]. ECB, 2011B. ECB announces measures to support bank lending and money market activity (CBPP2) [Press Release] 8December 2011. Available at: http:// www.ecb.int/press/pr/date/2011/html/pr111208_1.en.html [Accessed 26 March 2013]. FED, 2007. Federal Reserve will offer $20 billion in 28-day credit through its Term Auction Facility on December 17, 2007 [Press Release] 14 December 2007. Available at: http://www.federalreserve.gov/newsevents/press/ monetary/20071214a.htm [Accessed 26 March 2013].

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FED, 2008. Joint Statement by Central Banks [Press Release] 8 October 2008. Available at: http://www.federalreserve.gov/newsevents/press/ monetary/20081008a.htm [Accessed 26 March 2013]. Goldberg, L. S., Kennedy, C., & Miu, J., 2010. Central bank dollar swap lines and overseas dollar funding costs. National Bureau of Economic Research, wp15763. Gros, D., Alcidi, C., & Giovannini, A., 2012. Central Banks in Times of Crisis: The FED vs. the ECB. CEPS Policy Briefs, 276. Malamud, A., 2011. A leader without followers? The growing divergence between the regional and global performance of Brazilian foreign policy. Latin American Politics and Society, 53(3), pp.1-24. Nolte, D., 2007. How to compare regional powers: analytical concepts and research topics. ECPR Joint Session of Workshops, 7, p. 12. Pisani-Ferry, J., & Posen, A. S., 2009. The euro at ten: the next global currency?. Peterson Institute. Zwartjes, M., Van Langenhove, L., Kingah, S., &Maes, L., 2012. Determinants of regional leadership: is the European Union a leading regional actor in peace and security?. Southeast European and Black Sea Studies, 12(3), pp. 393-405.

Part II Financial Crisis in Greece and Spain

4

European financial crises: The Greek case

Introduction Europe generally enjoys economic and political stability with some exceptions. However, the Greek sovereign debt crisis has revealed the main weaknesses of the European system and institutions to effectively and swiftly respond to the challenge. The spillover effects of the crisis in the region are significant but a thorough analysis of their impact is beyond the scope of this paper. In Greece, the Prime Minister at the time, Yorgos Papandreou, announced his government’s decision, in October 2011, to hold a referendum for the acceptance of the terms of an EU bailout deal. The internal and external reaction to the announcement was immediate and generated panic in the markets and anger among its European partners forcing Papandreou’s resignation. Subsequently, the Greek elections took place in the midst of austerity measures and were closely followed by national, international and supranational actors. France and Germany played an important role in the Greek crisis. These countries actively participated in the search for a solution to the economic problems of their respective neighbors. Coordinated international and national efforts are necessary to successfully implement the required measures to help the country overcome the crisis. On the one hand, an ambiguous response from the key players may send a negative signal to the markets and can trigger negative consequences that might deepen the crisis. Suitable actions from national and international actors can contribute to reassure the markets that the situation is under control and that a viable solution will soon be implemented, thus sending a positive signal. The key players are identified and their role in the crisis is briefly described to demonstrate their impact. Finally, the problems Greece faced and the solutions employed are presented. 91

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This chapter concludes that crisis could have been foreseen if the appropriate institutions had fulfilled their respective responsibilities and acted accordingly; a high price to pay for lack of a timely and effective response. Speedy reaction, prompt intervention and appropriate means of communication with the markets are essential. More efficient economic governance is needed at all levels: regional, national, international, and supranational. Institutions play an important role and if they are provided with the necessary instruments, autonomy, and competence they can react and take the required measures to withstand any turbulence. Greek economic and financial crisis The current economic crisis is not only due to the financial crisis that began in the US, but also to the weakness of the Greek public finances. Greek governments have been increasing their debt since 1980, following an increase in government spending that was not offset by an increase in government revenue. Akram et al. (2011) show that a significant part of the Greek budget is military spending, which in most cases does not contribute to economic growth. With the accession of Greece to the euro area, government debt was stabilized (relative to GDP). Figure 4.1 shows an increase in the Greek public debt (% GDP) from 1980 to the early 1990s, after the debt is stabilized in the nineties, while in the 2000s the debt increases again.

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Figure 4.1 Greek government general gross debt (%GDP) 1980-2015

Source: Authors with data from the International Monetary Fund, World Economic Outlook Database, April 2016.

The Greek political system was weakened by the power of political parties and trade unions, so that the conditions were not generated in the 1980s and 1990s for structural reforms to be undertaken in order to have balanced public finances. Featherstone (2011) shows the weakness of the Greek public administration and the failure of the Greek government before the crisis to take appropriate measures to increase the country’s competitiveness, without incurring excessive deficits. Katsimi and Moutos (2010) point out that the weakness of the Greek public administration is due to the fact that Greek political parties were increasingly influential: The capture of the public administration by the political parties was cemented by the fragmentation of the unions representing public-sector workers along party-political lines, and by their overwhelming influence on personnel choice and promotion to potentially lucrative posts. In effect, this meant that able civil servants had to “take sides” and “declare their allegiance” with a particular political party if they wanted to avoid being left behind in their careers or to avoid punishment for any unlawful acts they may commit. As a result, many civil servants used great discretion in applying the rule of law: “politically-connected” citizens received favorable treatment (Katsimi&Moutos 2010: p. 6).

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As a result of the weak public administration, the budget was used for purposes other than those that would have contributed towards an efficient government, and that expenditure increased significantly, so that the public debt reached unmanageable levels. Kouretas and Vlamis (2010) identified three "key players" of the Greek crisis: First, the Greek government was weak to labor unions and political parties, which allowed the public debt to grow to unmanageable levels. Second, the credit agencies did not realize the weakness of Greek public finances in the years previous to the crisis, and when the crisis started, they overreacted. Third, the ECB and euro area authorities reacted too slowly. Figure 4.2 shows a comparison of the public debt of Greece, Spain, and Germany since the euro was launched. Greece has had a much higher public debt (% GDP)than Germany and even Spain. Weak public finances of Greece come from its entry to the euro area, but once inside the debt increased even more, showing that the SGP did not prevent euro area countries from overspending. Figure 4.2 General Greek, German and Spanish government gross debt (% GDP) 1999-2015

Source: Authors with data from the International Monetary Fund, World Economic Outlook Database, April 2016.

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Once inside the euro area, the Greek government benefited from cheap credit, the same interest rate as Germany and France. This situation has arisen because international investors gave the same risk to bonds of member countries of the euro area(Akram et al., 2001). However, in terms of competitiveness, Greece is far from its partners. Featherstone (2011) shows that the Greek sovereign debt crisis is due to the failure of previous Greek governments to address the structural problems of the Greek economy. Figure 4.3 illustrates that while Germany has reduced its ULC in the past decade, Greece, Ireland, Italy, Spain and United Kingdom have increased their ULC. Increased ULC has made Greece less competitive with respect to other European countries and the rest of the world. Greece was ranked 36th in the Global Competitiveness Index of the World Economic Forum in 2001, in 2016 it was ranked 81th.  

Figure 4.3 Nominal unit labor costs in Germany, Greece, Ireland, Italy, Spain and United Kingdom

Source: Authors with data from AMECO, European Commission.

In 2008 credit in the world declined, and in 2009 Europe showed problems related to the decrease in aggregate demand. The ECB as well as the FED and other central banks injected liquidity in the world markets with the aim of reducing the decline in GDP. The risk premium of Greek government bonds was not high in the middle of 2009. On October 4, 2009, Yorgos Panpandreu of PASOK (Panhellenic Socialist Movement) won the parliamentary elections

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and became Prime Minister by absolute majority; his party won 160 seats out of 300. A few days after, the Prime Minister announced that the government deficit in 2009 would be 12.7% and the public debt of 113.4%, above that estimated by the previous government. It was not the first time that the Greek government announced incorrect data, as it had already occurred when they entered the euro area. Skilas and Galatsidas (2012) show that the current Greek crisis is not a result of the financial crisis that began in the US in 2008, but neither is the mismanagement of economic policy of the right government of the pre-crisis period (2004 -2009). The authors attribute the Greek crisis to poor macroeconomic policies taken by the governments of the past three decades, making the Greek economy weak and vulnerable. Based on the above, Greece should not have joined the euro area, because it did not meet the requirements set by the Maastricht criteria. Much of the economic crisis affecting Europe is due to the facility with which Greece joined the euro area, without having fulfilled the convergence criteria and then to have incurred in over-indebtedness. Lane (2012) points out that the problem of the Greek crisis is the set-up of a EMU, with no Fiscal and Bank Union. Greece continued using its fiscal policy and shared a currency with countries with more stable public finances, generating incentives to over-borrowing in the international market. The SGP did not help Greece to stabilize its public finances, because the country failed and was not punished, but quite the contrary; in the period 2003-2007 there was a great expansion of credit in Europe that affected Greece. Furthermore, the clause "no bailout" created uncertainty among the markets about whether the EU would intervene during the lack of liquidity of the Greek government in early 2010. There is a problem of economic governance in the EU because it created incentives for countries to acquire debt, and then as the crisis deepened, markets interpreted that countries would not be easily rescued. After the announcement of the Greek President in October 2009, Greece faced a steady fall in the price of its bonds, which caused the risk premium to systematically increase in the following months. The credit rating agencies started to decrease the rating of Greek bonds, regarded as "junk". The maturity of Greek bonds was short term, so it created the conditions for the Greek government, which was nearly bankrupt. In this situation the Greek authorities requested a bailout from the EU and the IMF. The Greek government required a low interest loan to pay the maturities of their bonds and got two bailouts, which temporarily decreased financial pressures. In Greece there have been a series of reforms that included the reduction of public expenditure by reducing salaries, pensions, and subsidies. On the side of revenues both direct and indirect taxes were increased. These

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measures have led to a series of protests by trade unions and social organizations. Today, Greece is in the process of privatization of public enterprises that will generate additional revenue to the government. With the increase in the risk premium on Greek bonds, European authorities were concerned mainly by the “contagion” to its European neighbors. The European authorities estimated again the public debt of Greece and it was higher, prompting more concern. There was a discussion about whether the EU could rescue their partners, because in the EU Treaty it was forbidden to rescue European partners by European institutions in order to avoid moral hazard problems. Investors were left with the perception that the EU did not have a lender of last resort, so the price of the bonds in the secondary market rose in countries like Greece, Spain, Portugal, and Ireland. De Grauwe (2010) has pointed out that even if the Treaty forbids bailouts by European authorities, it does not forbid bailouts that may occur among partners. The European authorities (the Council of Ministers of the EU and the ECB) did not act in time (Featherstone, 2011), which generated more uncertainty among investors about whether Greece could be rescued or not. The first rescue was an IMF loan of €30 billion and €80 billion from the euro area members over a period of three years, on the condition that the Greek government had to undertake structural reforms in order to reduce its deficit and debt. The approval of the first rescue occurred in May 2010, while in July 2011 it was given a second bailout of almost €110 billion, with contributions from the EU and the IMF; in addition, €50 billion were voluntary contributions from banks. For the rescue of Greece, then for other countries, the EFSF was created and later became the ESM. To sustain the austerity policies of the Greek government, conditioned by the bailouts, the Troika was informally formed(the ECB, the IMF, and the European Commission) with the aim of monitoring the Greek austerity plan. The ECB bought Greek bonds on the secondary market to reduce pressure on the Greek risk premium. The “contagion” of the Greek crisis spread to Ireland and Spain, because their banking systems were rescued as well, while Portugal was rescued for the lack of liquidity for the payment of short-term bonds. Frankel (2011) mentions three mistakes of European authorities in the sovereign debt crisis: The first is having allowed Greece to enter the euro area, where Greece did not fulfill the Maastricht criteria; the second was to allow the interest rates gap between Germany and Greece which was virtually zero, when fundamental policies between those countries were completely different; third, the European authorities should have advised Greece to be rescued by the IMF (in January 2010), due to the non-rescue of the EU Treaty in the market, it generated ambiguity about whether the EU would be able to rescue Greece, raising the risk premium. Katsimi and Moutos (2010)

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suggest that the SGP does not take into account the current account deficits of the member states of the euro area, which has a long-term impact on the public deficit and public debt (now there is the macroeconomic imbalance procedure). Furthermore, these authors note that while much of the Greek crisis is due to the Greek government, it was the design and operation of the euro area that led Greece further into debt. The outlook for the Greek economy is not encouraging, because it is in a recession with a fall in GDP, which in the best case will grow but at a very low rate, because its potential output has fallen significantly. Moreover, the austerity measures implemented have had a negative impact on economic growth. One of the fundamental problems of the Greek economy is its low competitiveness, because their products are not competitive with those of its European neighbors. To improve the competitiveness of the Greek government requires the approval of structural reforms. Elections in July of 2012 were won by Andonis Samaras (New Democracy), who is ruling with PASOK, after the administration by the government of former Prime Minister Lukas Papademos. The last three governments have had a series of general strikes, hampering governance, because on the one hand the government is seeking the confidence of international investors and the Troika, through the implementation of the austerity plan; on the other hand, the implementation of the plan has generated much anger among the population because of the application of cutbacks. Thus, the current Greek government has to implement unpopular measures in times when the economy slows down and unemployment is at the highest levels in recent decades, which leaves very little room for the government. De Grauwe (2011) shows that the formation of the monetary union in the EU generates an internal dynamic that fosters the crisis, because member states issue debt in a currency that is not their own, so that incentives are generated in markets to cause peripheral countries falling into insolvency. The author criticizes the ESM, because this mechanism will provide loans to high interest rates, which will increase the public deficit and risk premiums will rise. The underlying problem for Greece is that the EU has not solved its problems of economic governance, preventing that in the short and medium term financial crisis is resolved. Garcia and Ghezzi (2011) find that even after the bailouts and austerity plans in Greece, it is not entirely sure that this country can solve its public finances and competitiveness. The solution of the Greek problem is to foster a more competitive economy; otherwise the austerity plans will generate only a temporary improvement.

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Key players in the crisis Important actors that had a bearing on the Greek crisis can be identified. Their actions or indecisions have an impact on the markets. Key players can reassure or send an alarm signal to the markets. In the Greek crisis, the slow actions taken by the European institutions, the different points of view of the Member States concerning the bailouts, and the citizens’ reaction to the austerity measures implemented by the Government sent a negative signal to their creditors. Governments and international institutions play an important role to prevent and curtail economic and fiscal crisis. The European Union institutions and the Troika Member states had been reluctant to coordinate supervision and regulation of financial markets, until the Greek crisis. The failure of the EU institutions to identify, alert and act in the early stages of the crisis was in many ways disappointing. When the Greek crisis erupted, both the Council of the EU and the ECB failed to provide a suitable and efficient response. They had not anticipated a bailout for a euro area country and they were ill-equipped to deal with the crisis. According to Featherstone (2011), the indecision and delay in the response by the Ecofin and the European Council increased the cost of intervention (of the bailout loan for Greece and the rescue mechanism for the euro area) as the price to convince markets increased over time. The initial response to the Greek crisis by the EU institutions and leaders of member states was mainly based on the risk of moral hazard. Most of them believed that any debt relief would pose a moral hazard problem to other debtor member states. There was an underlying risk that euro area countries would infringe the SGP and expect their debts to be erased. The German Chancellor, Angela Merkel, was a staunch believer of this principle and on implementing severe austerity measures in Greece. Other leaders, such as the President of France, Francois Holland, contend that through growth the Greek economy would improve. Since then, the EU’s position has interestingly shifted and the new proposal includes private creditors. Basically, the strategy consists in that all owners of Greek bonds should “voluntarily” accept a 50% reduction of their bonds. The Troika, composed by the European Commission, the IMF and the ECB was invested with the responsibility of monitoring the economic adjustment program approved by the Greek parliament, the IMF, and the European leaders. The first rescue package was a response to the request made by Greece for official financial assistance. The second rescue package was necessary since the first one proved insufficient.

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The euro area Member States, based on the decision of the Ecofin Council, created a temporary rescue mechanism, the EFSF, in 2010. The aim was to preserve financial stability in Europe. In 2012, a permanent recue mechanism, the ESM entered into force and is the main instrument to finance new programs. The Greek response to the crisis The low credibility of the Greek government and the data they provide were important factors considered to assess the ability to borrow by the international financial markets. In a press release by Eurostat (2009) a reservation on reported data by Greece stated as follows: “Eurostat has expressed a reservation on the data reported by Greece due to significant uncertainties over the figures notified by the Greek statistical authorities”. The political turmoil and social unrest added stress to the severe economic problems. The Greek government requested financial assistance from European countries and the IMF, as well as, adopted important austerity measures, wide-ranging reforms to the healthcare and pension systems and public administration to confront the crisis. From February 2010 to 2012, the Greek government implemented strict austerity packages. They included a freeze in government employees’ salaries, a cut in bonuses, a cut in the salaries of private and public employees, a rise on VAT and tax petrol, among others. These measures have encountered strong opposition by Greek citizens. The bailout and its economic consequences The bailout Greece had entered the Eurosystem in 2001 and its monetary policy was not independent, because Greece it did not have its monetary policy when it entered to the EMU, monetary policy was run from Frankfort. In the case of Greece, the current account deficit was due to their low competitiveness with its trading partners, due to the increase of ULC. When Greece entered the EMU it was searching price stability through a fixed exchange rate, because in previous years, devaluations had been transferred to prices. The markets did not anticipate the Greek crisis because months before the rating agencies did not provide sovereign debt ratings consistent with the credit risk. Moreover, at the time of the crisis, the markets overreacted causing the crisis to further exacerbate. Greece entry into the EMU gener-

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ated certainty, because the country shared the euro with countries with a very low risk, such as Germany. Years before the crisis, Greece had access to credit at very low interest rates that led to economic growth in the period 2003-2007. The Greek economy was poorly based, it had an excessive deficit in the current account, a debt that was becoming increasingly unsustainable and a low level of competitiveness, but that fact was not shown by the rating agencies in their reports on sovereign debt risk. In the crisis, investors were buying debt denominated in currencies that countries could not be issued, the euro for Greece. The Central Bank of Greece could issue euros, which made the issue of these bonds very risky; however, most of the debt was short term. The role played by rating agencies was critical because it somehow delayed the onset of both crises, making them deeper. Bailout occurred, where supranational actors were involved and conditioned the economic policies of Greece in the years after the crisis. The EFSF (which later became ESM) in the case of Greece, where capital contributions are headed by Germany (27%), France (20%), and Italy (18%), and other euro area countries contribute 35%. Germany was the protagonist because it was the country that gave more money to the rescue and because there was internal resistance to rescue Greece. In the case of Greece, it was the Troika. The ECB also intervened by buying Greek sovereign debt on the secondary market. The crisis began days after former Greek President Papandreou announced that the deficit would be higher than expected (mid-October 2009) and the rescue occurred in early May 2010, after several meetings of heads of state and government of the euro area, which increased doubts on whether Greece would be rescued or not. The loan terms was for a period of three years without the possibility to exchange their national currency into Euros. The rescue was delayed a few months, by the refusal of some heads of state and government to grant the rescue, due to the global financial crisis and by the absence of a European crisis mechanism. Economic consequences The Greece unemployment had risen, while the economy had fallen back in 2011 and it appears it would happen again in 2012 and 2013. The pressures of the Troika and the signing of the International Treaty of austerity have generated pressure for deficit reduction. Using the exchange rate as a tool to grow in the short term should not be underestimated, because it allows an increase in exports that can generate economic growth. Obviously in the long term it cannot be systematically used because it generates negative effects, but in the short term and in the

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middle of an economic crisis, devaluation could help economic recovery. Figure 4.4 shows that the performance of Denmark, United Kingdom and Sweden (with their own monetary policies) after the crisis was better than the Greek economy has had after 2008. The growth rates of the Greek economy have been negative since 2009, while the others economies grew at 2% (average) in 2010-2015. Figure 4.4 GDP Growth (%) Denmark, Greece, Sweden and United Kingdom

Source: Authors with data from the International Monetary Fund, World Economic Outlook Database, April 2016.

Figure 4.5 shows that the performance of Cyprus, Ireland, Portugal and Spain (bailed out countries)after the crisis was better than the Greek economy has had after 2008. The growth rates of the Greek economy have been negative since 2009, while the others economies grew at positive levels (average) in 2010-2015.

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Figure 4.5 GDP Growth (%) Cyprus, Greece, Ireland, Portugal and Spain

Source: Authors with data from the International Monetary Fund, World Economic Outlook Database, April 2016.

For the Greek case, the option of using the exchange rate has not been raised by its government due to the costs that such an action would bring. However, the scenario was not the best, because it was in a recession. Furthermore, although the main mistake of the Greek crisis had been the mismanagement of public finances by the Greek government, poor European economic governance deepened the crisis. Greece has to gain competitiveness through structural policies that make this economy more competitive, since it cannot use the exchange rate tool. Furthermore, it should generate better economic governance within the euro area to avoid the vulnerability that has been exposed to Greece, but at the same time should not create incentives for more bailouts. The International Treaty on Austerity that takes effect in 2013 should become an important element to improve the economic governance of the EMU, however it needs to be further advanced. Many alternatives have been proposed to avoid another crisis such as the Greek, including greater political integration, the creation of European bonds, and the European Monetary Fund

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Conclusions The crisis had not only economic but also political factors that had a negative impact on their economies, they also had, before the crisis, large current account deficits, and the risk of a spillover effect in their respective regions was justified. For Greece, the slow reaction of the EU supranational institutions hindered a prompt solution and amplified the costs associated with the crisis. It is important to highlight that in the case of Greece there was a global economic crisis. Economic governance with suitable monitoring mechanisms is essential to prevent this type of crisis. Coordinated efforts should be taken and institutionalized at all levels (regional, national, international and supranational) to respond promptly in order to take remedial actions that may prevent and curtail any crisis. The EU and, especially, the euro area should strengthen and deepen their economic and monetary policies taking into consideration lessons learned from this and other crises to pursue an effective strategy to prevent and manage crisis. Considering the globalization process and technological advances, more research should be done on how the institutions can improve their communication skills to interact among them and with the international markets. Also, a study on the spillover or domino effects of the Greek crisis at all levels could yield proposals and measures that could limit the negative effects in other countries. An analysis of the economic interdependence of the European Member States and the future of the euro should focus on solutions to advance the EU’s Economic and Monetary Union and consolidate the European governance to avert threats and make the most of opportunities.

References Akram, M., Sajjad, H., Fatima, T., Mukhtar, S., & Alam, H. M., 2011. Contagious Effects of Greece Crisis on Euro-Zone States. International Journal of Business and social Science, 2 (12), pp. 120-129. De Grauwe, P., 2010. The Greek Crisis and the Future of the Euro-Zone. EuroIntelligence. [online] Available at. < http://www.eurointelligence.com/ > [Accessed 15 September 2012] De Grauwe, P., 2011. The Governance of a Fragile Eurozone. Md. University of Leuven. [online] Available at. [Accessed 9 October 2012].

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Featherstone, K. 2011. The Greek Sovereign Debt Crisis and EMU: A Failing State in a Skewed Regime. Journal of Common Markets Studies. 49 (2), pp. 193-217. Frankel, J. 2011. The ECB’s Three Mistakes in the Greek Crisis and How to Get Sovereign Debt Right in the Future. VoxEU, [online] Available at [Accessed 9 October 2012]. Frankel, J., & Schmukler, S., 1998. Crisis, Contagion, and Country Funds: Effects on East Asia and Latin America. In: R. Glick, ed. Managing Capital Flows and Exchange Rates. Cambridge: Cambridge University Press. pp. 232-266 Garcia, A. & Ghezzi, P., 2011. The Greek Crisis: Cause and Consequences. CESifo Working Papers Series, No. 3663. Katsimi, M., & Moutos, T., 2010. EMU and the Greek crisis: Are there lessons to be learnt?. European Journal of Political Economy, 26(4), pp. 568-576. Kouretas, G. & Vlamis, P., 2010. The Greek Crisis: Causes and Implications. PANOECONOMICUS, 4, pp. 391-404. Lane, P., 2012. The European Sovereign Debt Crisis. Journal of Economics Perspectives, 26 (3), pp. 49-68. Sklias, P. & Galatsidas, G., 2010. The Political Economy of the Greek Crisis: Roots, causes and Perspectives for Sustainable Development. Middle Eastern Finance and Economics, 7, pp. 166-177.

5

Euro area governance in times of crisis: Enough for Greece and Spain?

Introduction In the wake of the crisis, the response of the EU institutional framework was weak, slow and lacked the necessary instruments. The institutional crisis (e.g. EMU) combined with the financial (e.g. international), fiscal (e.g. Greece), banking (e.g. Ireland) and competitiveness crisis (e.g. Portugal) have triggered one of the most profound crises in the EU’s history that threatens its stability. As long as national governments continue to control fiscal policy and banking regulations, European institutions will be limited in their actions when crises, such as the on-going one, arise. The European policy response will remain frail and any progress towards the euro area economic governance, frozen. There are many costs to join a monetary union but also ample benefits. One of the most important challenges is the institutional design to ensure the efficiency of the system. Supranational and national institutions are constantly interacting in a horizontal and vertical governance system. The European governance system is complex and policy coordination can be difficult. During the on-going crisis, the economic governance in the euro area has revealed important flaws in the design that triggered negative spillover effects. The European policy response has been criticized in the literature for the lack of appropriate response, and untimely involvement of some institutions. The flaws in the institutional design allow for certain member states to steer the decision making at the EU-level. Considering that there is a natural tendency of member states to award national interests a privileged place in their decision making process in detriment of supranational interests, this is not the optimal scenario to find the best solutions to the current European challenges. The response to the crises by the ECB was slow, and markets reacted to the hesitation. The different views within the governing council of the ECB 107

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made it difficult for them to react decisively and calm the markets. This paper analyses the economic governance in the euro area and assesses if it is pertinent for Spain and Greece to continue in the monetary union. Further on, these countries’ economies will be compared to those of the UK and Sweden, which are also members of the EU but are not part of the monetary union, in order to determine if Spain and Greece should continue using the euro. This paper demonstrates that important factors such as the economic governance in the euro area as well as internal factors in these countries had a significant impact on the outcomes of the crises. The stability of the euro area can be achieved if the economic governance of the EU is strengthened. Theory of optimum currency areas Criteria to form an optimal monetary area The Theory of OCA was born when there was a discussion on the use of exchange rate regimes. In the world there was the Bretton Woods, a system of fixed but adjustable exchange rates. Friedman (1953) proposed that when there was not full flexibility of prices and wages, it was better to have a system of flexible exchange rate, because it allowed countries to have a tool to counter asymmetric shocks. Mundell (1961) pointed out that for two countries to integrate monetarily (fixed exchange rate), labor mobility is necessary. Labor mobility is considered an element of optimality, because in the presence of asymmetric shocks, workers can move from a crisis region to a booming region, in this way it is not necessary to adjust the exchange rate to deal with asymmetric shocks. McKinnon (1963) observed that when the economies are more open, using the exchange rate as a tool against asymmetric shocks is less efficient. Thus, a requirement to integrate monetarily is that countries have a high degree of trade openness. Kennen (1968) noted that when countries are more diversified, asymmetric shocks have less effect on the economy as a whole, therefore it is not necessary to adjust the exchange rate to offset asymmetric shocks. Petreski (2007) showed that when a group of countries share the same currency, a fiscal transfer system functions as a substitute for exchange rate. Instead of using a variation of the exchange rate to face an asymmetric shock, a country could receive a fiscal transfer of a group of countries with a good economic situation. Regarding fiscal integration, it is important to note that this is preceded by political integration, i.e., when countries are integrated into a federation, there is a federal budget.

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De Grauwe (2006) shows that a political union is an important element for economic governance, when there are countries that share a common currency. When two countries are integrated politically, the monetary integration is easier. Alesina, Spolaore and Wacziarg (2000) show that economic integration leads to political integration among countries; in other words, as countries are more integrated economically, the political boundaries among them are reduced. Petreski (2007) explained that financial integration is a substitute for exchange rate adjustment. Financially integrated countries sharing the same currency do not need the exchange rate as a tool to deal with asymmetric shocks, because a small change in the interest rate generates capital flows that move from one country to another, i.e. financial integration is an insurance against asymmetric shocks in countries that share a common currency. When a country's trade is more concentrated in a few partners, the greater the savings from reduced transaction costs in the presence of a single currency (Dellas and Tavlas, 2001; Eichengreen, B. 1994). In this way, countries should share a currency if they had high trade agreement among them, unlike the countries that have a symmetrical distribution of their trade. Alesina, Barro and Teneyro (2003) show that countries with a high inflation rate are more likely to use the currency of a country with a good record of inflation. Thus, the incentive to import another country’s stability is increased when countries have bad experiences with regard to inflation. Benefits and costs of a monetary area Another way to study the decision to form a monetary union, is to analyze the costs and benefits of forming a currency area (Dellas and Tavlas, 2001; Alesina, Barro and Teneyro, 2003; De Grauwe, 2007; Horvath and Komarek, 2002). When benefits exceed the costs, it is optimal for countries to integrate monetarily. At the theoretical level, there is some consensus on the benefits of a monetary union; however, there is no consensus on the size of the costs. When a group of countries share a common currency, the cost of exchanging currencies is reduced (De Grauwe, 2007). A fee has to be paid when there is a flexible exchange rate for changing domestic currency into foreign; this cost is higher when there are large variations in the exchange rate. When a country in a monetary union reduces uncertainty on investment decisions, it stimulates economic growth (De Grauwe, 2007). When companies are not affected in their decisions to invest, the economic growth is boosted, because there is more investment in relation to a stage with a flexible exchange rate.

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McCallum, J. (1995) notes that a monetary union is seen as a more durable and serious commitment. Compared to other monetary arrangements, the monetary union is perceived in long terms, opposed to a dollarization, which may be temporary. The costs of abandoning a monetary union are higher compared to other monetary arrangements, therefore, it is perceived as a lasting agreement. In countries with inflationary problems, to form a monetary union can be considered a benefit. Alesina, Barro and Tenreyro (2003) show that countries with severe inflationary problems that adopt the currency of a country or currency area with credibility, gain the commitment of that country or currency area to fight inflation. The traditional cost of monetary integration is the loss of monetary and exchange rate policy to deal with asymmetric shocks. In this regard, governments can use the Phillips curve to choose a combination of inflation and unemployment points. In the early 1980s, the concept of time inconsistency of monetary policy and the criticism of the Phillips curve arose, and losing monetary policy was no longer a cost, because governments can no longer reduce unemployment below its natural level. To use the Phillips curve generates inflation and unemployment is not reduced. The exchange rate is no longer a tool to reduce unemployment; therefore, the cost of having a fixed exchange rate is not high. Endogeneity of optimum currency areas Frankel and Rose (1997) were the first to discover that belonging to a monetary union generates endogenous effects that allow members to meet the conditions to be part of an OCA. Thus, even if the countries do not fulfil the conditions to be part of an OCA ex ante, they can fulfil them when they are the part of a monetary area. The endogenous effect is based on the idea that when a group of countries share the same currency, trade increases between them (Rose and Stanley, 2005). On the other hand, when there is more trade between countries, the synchronization of business cycles increases (Frankel and Rose, 2007). In this way, when the same currency is shared, the intra-industrial trade increases, causing more synchronization of business cycles. Spain/Greece and the United Kingdom/Sweden: Different monetary strategies There have been several studies with regard to the optimal use of the euro in the euro area countries, and the vast majority have found that the countries

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that share the euro are not an OCA. Germany, France and a small group of countries form an OCA, but in none of the cases Spain, Greece, UK nor Sweden are included. The passing of time could give an endogenous effect for Spain and Greece for being part of the euro area, therefore these countries are now closer to forming an OCA with the euro area; however, there is no evidence of such a situation. From the theoretical point of view, the entry of Spain and Greece to the euro area is not justified, because they do not fulfil many of the conditions required to form an OCA, and it is not at all clear that the benefits outweigh the costs to use the euro in these countries. On the other hand, the refusal to use the euro by the UK and Sweden is supported theoretically, because these countries do not fulfil many of the conditions to be considered as an OCA. If we use the criterion of labor mobility, the euro area is not an OCA, because there is no perfect labor mobility over the entire region, due to a variety of economic, social and cultural barriers among its members. If we take the criterion of Mundell, in times of crisis it is not optimal for Spain and Greece to share a currency with the group of the euro area countries, because there is not perfect mobility of labor in such a currency area, which allows to smooth the effects of the crisis. The criterion of McKinon advises that Spain and Greece should use their own currencies, while the UK and Sweden should use them to a lesser degree, because their degree of trade openness is not comparable as countries, which considered Belgium, the Netherlands and Luxembourg as an OCA. The other criteria would advise the use of national currencies for the above countries, but especially for Spain and Greece. There are two factors why Greece and Spain are using the euro: the first is the political agreement reached among European countries to deepen economic integration, which included the launch of the euro as a measure to deepen the internal market. The second factor applies not only to Greece and Spain, but to all the so-called PIGS countries. The monetary stability would provide a new central bank and a new currency, the ECB and the euro, because these countries historically had periods of instability in their currencies and high inflation. Greece and Spain ceded their monetary and exchange rate policy to a supranational institution to import stability. In the case of the UK and Sweden, their strategies were different, because it gave more independence to their central banks, and they adopted the monetary policy of inflation targeting and flexible exchange rate. Spain and Greece have been members of the euro area since 1999, when their governments signed the Maastricht Treaty, while the UK and Denmark negotiated a clause "opting out" that allowed them to join the euro at any time. The case of Sweden is different, because that country joined the EU in 1995, it could not negotiate an "opting out" clause. The Swedish government

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held a referendum on the use of the euro and citizens said "no" to the euro, so for that reason Sweden does not use the euro. The four countries mentioned above do not form an OCA in the euro area, but while the UK and Sweden are still using their own currencies and have autonomous monetary policy, Spain and Greece use the euro and do not own a monetary policy. With the global financial crisis, the UK and Sweden had monetary and exchange policies that were managed by the BoE and the Riksbank to mitigate the effects of the crisis in these countries, while in the case of Spain and Greece, the monetary and exchange rate policy were managed at the supranational level by the ECB, with targets for the entire euro area, which is only marginally affected by developments in these economies. Good economic governance in a currency area allows better management of an economic crisis, even if a monetary region is not an OCA. The central idea is that what happens in one country does not affect the entire monetary region, so it is necessary that the supranational institutions have tools that create good economic governance. Economic governance in the euro area during the crisis Various measures and mechanisms have been introduced at the EU-level to contain the financial crisis. Among the measures, a task force on economic governance was created and chaired by the European Council President Herman Van Rompuy in 2011. The same year, the member states approved the so-called “Six-Pack”, which comprised five regulations and one directive. In May 2013, the so-called “Two-Pack” entered into force to complete the budgetary surveillance cycle and improve the economic governance of the euro area. Also, two mechanisms were created in 2010 to grant European countries conditional financial assistance: the EFSM and the EFSF. Safeguards of economic governance There are three main safeguards of Economic Governance at the EU-level, the Maastricht criteria, the SGP and the ESM. In order to adopt the euro, European countries must meet the five criteria established by the Treaty of Maastricht. The first is inflation of no more than 1.5 percentage points above the average rate of the three EU member states with the lowest inflation over the previous year. The second, a national budget deficit at or below 3% of GDP. The third, a national public debt not exceeding 60% of GDP or on a downward path. Fourth, long-term interest rates should be no more than two percentage points above the rate in the three EU countries with the lowest

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inflation over the previous year. Fifth, the national currency is required to enter the ERM 2 years prior to entry. The SGP is a framework to coordinate national fiscal policies in the EU with the aim to uphold the stability of the EMU (low inflation, interest rates and controlled debt and spending). This agreement has a two-fold objective: to ensure a sound fiscal policy over the cycle and to take the appropriate measures in case there is an excessive deficit. Another important safeguard of economic governance is the ESM, which provides assistance to euro area members with financing difficulties. The predecessor of the ESM is the EFSF set up temporarily in 2010 and will eventually cease to exist once all the loans and funding instruments issued are repaid in full. With the crisis, the EU’s economic governance was exposed and the weaknesses were revealed. The EU’s response during the crisis was, in some cases, frail and slow triggering negative effects in the international financial markets that reacted intensifying the threat of total collapse of some of the largest financial institutions and defaults by governments. Weaknesses in the economic governance There are mainly three areas that have been identified as the source of the main weaknesses in the European economic governance: surveillance, coordination and sanctions. The surveillance and coordination of economic policies in the EU, before the crises erupted and new mechanisms and reforms were introduced, was inadequate at best. The enforcement mechanisms that existed were not used and the EU institutions did not compel member states that did not fulfil their obligations. The lack of economic sanctions in case of failure to fulfil the requirements fosters non-compliance among member states. There is a lack of budgetary discipline in some member states. The EU responded to the crises with a new set of rules, which were presented in order to achieve a stronger preventive action by reinforcing the SGP and a deeper fiscal coordination. There are internal, external and mixed surveillance or monitoring mechanisms in the EU. In the internal mechanism, the European institutions play an important role. According to Article 121 of the TFEU, the European Commission submits reports to the Council in order to monitor economic developments in each of the Member States in the Union as well as the consistency of economic policies. In article 126 of the same treaty, the European Commission shall monitor the development of the budgetary situation and of the stock of government debt in the member states to identify gross errors. The Council of the EU and the ECB are also an important part of the internal mechanism.

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Within the external surveillance and monitoring systems we find the rating agencies, international organizations and other organizations. Both failed to foresee the financial problems in countries such as Greece, Spain, Italy and Portugal, among others. The question arises about their efficacy, specifically with regards to the rating agencies, at the international level. A mixed surveillance and monitoring system is for example the Troika (European Commission, ECB and the IMF) where EU institutions and an international organization work together. The IMF provides policy advice, in some cases financing, technical assistance and economic analysis as part of the surveillance mechanism set up for member states that receive financial assistance. The aim is to coordinate efforts to ensure coherence and efficiency in the euro area as a means to achieving sustainable growth and job creation. The framework for economic cooperation is the EMU. The aim of this cooperation is to promote growth, jobs and a higher level of social welfare for all; to respond to global economic and financial challenges in a coordinated way; and to make EU countries more resilient to external shocks. In the EU, there is a coordination failure and member states lack the political will to increase the degree of political union. Thus, the euro area is fragile and will remain so if member states do not move forward towards a more political union. As noted by De Grauwe (2011), a serious design failure of the euro area is the fact that while monetary policy is centralized, other instruments of economic policies have remained in the hands of national governments. Member states should gradually hand over sovereignty over the use of these instruments of economic policies to the European institutions. According to Herzog and Hengstermann (2013), since the establishment of the EMU there have been more than 60 breaches of the SGP without any consequences. In 2003, France and Germany breached the deficit threshold and they did not even receive a blue letter (early warning) by the EcoFin Council to remind them of their obligations. The economic governance in the euro area is weak and as long as there is difficulty in activating the enforcement mechanism or the member countries are reluctant to enforce the rules, it will remain so. The enforcement mechanism should encompass rules and procedures where it can be activated without the consent of the member states if there is an infringement. The European Fiscal Compact can help to prevent excessive deficits, because it includes stricter parameters and penalties that may discourage countries to have a high public spending. Generally, with regards to European legislation, the European Commission is monitoring compliance and if there is a violation, it will act and it does not need the approval of the member states. One of the advantages is that it avoids frictions among member states and their natural instinct to protect their national interests over the supranational. Without the judicial activism

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of the European Court of Justice and the role of the European Commission, the internal market would not have been achieved as it was. Member states have to keep in mind that their decisions have an impact not only in their respective countries but also in others. A similar enforcement mechanism should be established to ensure compliance of the rules and to monitor progress of the euro area. It is of utmost importance to avoid what happened in Greece, where the government reported data that was later found inaccurate. Pre-emptive measures to reduce or eradicate moral hazard are vital for the functioning of the EMU. Discretion and political influence are not acceptable in the enforcement mechanism if the economic governance is to succeed. In September 2012, the President of the ECB, Mario Draghi announced a new unlimited bond-buying program, OMT, for struggling euro area countries. Under this program, the ECB can undertake OMT in secondary markets under certain fiscal conditions. Even though this scheme was not adopted unanimously, it has been credited with restoring calm in the euro area and it has been very effective. Even though, to date, the ECB has not bought a single bond under the program, it has already helped to noticeably lower the Greek and Spanish bond yields. Many experts argue that the weak governance allowed countries like Greece to develop high debt and deficit levels. In sum, the flaws in the institutional organization of the euro area contributed to the European crises and the moral hazard problem. Failures in the economic governance exacerbated the crises. According to Eijffinger and Hoogduin (2012) the ECB was forced to take reaching unconventional measures that caused strains within the Governing Council. The different views concerning the adequate response to the crisis of the euro area countries made it more difficult to adopt a supranational perspective in favor of a more nationalistic stance. Comparative analysis of Spain/Greece and the United Kingdom/Sweden: Monetary policy in times of crisis Monetary and exchange rate policies during the global financial crisis: European Central Bank, Bank of England and Riksbank Monetary policies implemented by the BoE and the Riksbank are different from the ECB's monetary policy. The main objective of the ECB is price stability, while in the case of the BoE and the Riksbank it is the price and financial stability, where the latter was included for the effects of the global financial crisis. The quantitative objective of inflation is very similar in these central banks, because in the three cases, it is centered at 2%, although in the

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case of ECB its objective is inflation near but below 2%, while for the BoE its established range is about 2 (1% - 3%) and the Riksbank is 2%. Table 5.1 Monetary and exchange rate policies: The Federal Reserve, European Central Bank, Bank of England and Riksbank Monetary Policy: objective

ECB “To maintain price stability is the primary objective of the Eurosystem and of the single monetary policy for which it is responsible. This is laid down in the Treaty on the Functioning of the European Union, Article 127 (1) “Without prejudice to the objective of price stability”, the Eurosystem shall also “support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union”. These include inter alia ‘full employment’ and ‘balanced economic growth.’

BoE “One of the Bank of England's two core purposes is monetary stability. Monetary stability means stable prices - low inflation and confidence in the currency… However, in March 2009 the Bank's Monetary Policy Committee announced that in addition to setting Bank Rate, it would start to inject money directly into the economy by purchasing assets - often known as quantitative easing.” “The Financial Services Act 2012 established an independent Financial Policy Committee (FPC), a new prudential regulator as a subsidiary of the Bank, and created new responsibilities for the supervision of financial market infrastructure.”

RiksBank “The Riksbank’s primary functions are to safeguard price stability and financial stability. According to the Sveriges Riksbank Act (SFS 1988:1385), the goal of the Riksbank's activities is to maintain price stability. The Sveriges Riksbank Act also specifies that the Riksbank shall promote a safe and efficient payment system. Put simply, this concerns working in different ways to ensure that the financial system is stable and functions smoothly.”

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Quantitative objective

“… The ECB aims at inflation rates of below, but close to, 2% over the medium term”

Monetary Policy Schema Exchange rate schema

Two pillars schema: economic pillar and monetary pillar Floating

“The inflation target of 2% is expressed in terms of an annual rate of inflation based on the Consumer Prices Index (CPI)… [1%...3%]” Inflation targeting

“More precisely, the Riksbank's objective is to keep inflation around 2 per cent per year”

Floating

Floating

Inflation targeting

Sources: Central Banks’ websites

The BoE and the Riksbank have a scheme of inflation targeting, which consists in establishing a monetary policy decision, taking into account expected inflation. The ECB has a strategy for two pillars, one of them is an analysis of the main economic variables, while the other is an analysis of monetary conditions. The euro area, the UK and Sweden have a floating exchange rate regime, which means that central banks do not intervene in the exchange market, however, with the global financial crisis, these central banks took non-ordinary measures which impacted the exchange rate. Monetary and exchange rate policies applied by the ECB, the BoE and the Riksbank were different to those applied even before the global financial crisis, due to the magnitude of the latter. Initially, the three central banks reduced their reference interest rates to near zero, and implemented programs to provide liquidity to the financial system, however, the difference was that while the Riksbank and the BoE implemented some variations of the QE, the ECB did not implement a QE, because the CBPP1, CBPP2 and SMP were sterilized, so that the effects on the economy were different. Gros, Alcidi and Giovanni (2012) showed that CBPP1, CBPP2 and SMP had very limited effect in relation to the QEs implemented by the FED and the BoE. In 2011, both the Riksbank and the ECB raised their reference interest rates, but subsequently decreased again, while the BoE held its reference interest rate at levels very close to zero.

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Figure 5.1 Reference interest rate: European Central Bank, Bank of England and RiksBank

Sources: Central Banks’ websites

Effects of the crisis in Spain/Greece and the United Kingdom/Sweden This section analyses the effects of the global financial crisis in key economic variables of Spain/Greece and the UK/Sweden. Monetary and exchange rate policies of Spain/Greece have been handled by the ECB during the global financial crisis, while in the case of the UK/Sweden these policies are handled by the BoE and the Riksbank. Figure 5.2 shows the evolution of GDP (index) of Spain/Greece and the UK/Sweden since 2007 to forecast 2013. The global financial crisis affected the four countries in 2009, but the recovery that occurred after differs among countries. The UK/Sweden had a steady recovery from 2010 to 2013, particularly Sweden has recovered at higher rates than the UK, but in both cases the GDP is already higher than levels recorded before the global financial crisis. Spain/Greece show a negative trend of their GDP since the global financial crisis, in addition to the level of economic activity for 2013, which is much lower than that recorded in 2007. Spain had an increase of GDP in 2008, but from that year shows a negative trend that is only interrupted in

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2011, with almost zero growth, while Greece shows negative rates in all years from 2008-2013. Figure 5.2 Gross Domestic Product (constant prices)

Source: IMF

Figure 5.3 shows the evolution of the unemployment rate for the group of countries. Spain and Greece reported steady increases in the unemployment rate from 2007 through 2013, however, the trend was different because the increase in unemployment in Spain was pronounced in 2009, while in Greece occurred with greater intensity in 2011 and 2012. The UK and Sweden showed a rise in unemployment in 2009, but from that year their unemployment rates were stabilized, although not in the levels before the global financial crisis. From Figure 5.3, we show that the global financial crisis affected unemployment in Spain/Greece more intensely.

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Figure 5.3 Unemployment rate

Source: IMF

Figure 5.4 shows the levels of public debt (% GDP) from 2000 to 2013. From 2000 to 2007 Spain shows a downward trend, because its debt represented 60% of GDP in 2000 and reached a value close to 40% in 2007, while in the case of Greece, in the period 2000-2007, its debt increased at levels around 100%. The UK/Sweden had a similar public debt value in 2007, however, the path has been different in both countries, because the UK’s debt was around 40% in the period 2000-2007, while Sweden decreased public debt from 60% in 2000 to 40% in 2007. In the period 2007-2013 there is a general increase in public debt, with the exception of Sweden that holds levels of around 40%. The UK and Spain have a steady increase in public debt, because in 2007 they had a value close to 40% and in 2013 they have a value close to 100%, while Greece's debt goes from 100% in 2007 to reach 180% in 2013.

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Figure 5.4 Gross government debt (% GDP)

Source: IMF

Figure 5.5 shows the deficits for the group of countries from 2000 to 2013. Greece consistently had deficits throughout the period of analysis, as well the values increased from 2000 to 2009, except for 2005 where the value was lower than the previous year. From 2010, public deficits in Greece began to decline due to fiscal consolidation conditions imposed by the Troika. The UK had public surpluses in 2000 and 2001, while in the period 20022007 it had deficits around 3%. From that year the deficit increased sharply to 10% in 2009 and then there was a steady decline in the budget deficit until 2013, where there was a forecast of 7%. Spain applied a policy of reducing the public deficit from 2000 to 2007, and even in some years there were surpluses, however, in 2008 and 2009 there was an increase in the deficit that reached above 10% and remained until 2012. Finally, Sweden had deficits close to zero and surpluses, and even though its deficit during the crisis increased, the values remained around zero, because a year before the crisis it had a surplus of close to 5%.

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Figure 5.5 Public deficit

Source: IMF

Figure 5.6 shows the long-term interest rates in four countries. It is noteworthy that until 2008 the interest rate was very similar to the group of countries, although they did not share the same currency. From 2009, the interest rates rose for Spain, but especially for Greece. In the case of the UK/Sweden, the interest rates show a downward trend to levels below 2%. Spain and Greece, share the same currency, recorded much higher interest rates than their euro area partners, although such a zone holds the same monetary policy. In 2013, there had been a decline in interest rates in Greece and Spain due to the decision of the ECB to announce that it would buy unlimited amounts of sovereign debt in the secondary market if the risk premium of the euro area increased. Spain and the UK have had very similar levels of deficits and debt in the past decade and so far this decade. However, long term interest rates are much higher in Spain than in the UK, which shows that markets have reviewed other variables in the secondary markets. The European sovereign debt crisis has caused risk premium to reach very high levels in the summer of 2012, nevertheless, the promise of ECB to buy unlimited amounts of sovereign debt in the secondary markets has diminished the Spanish risk premium.

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Figure 5.6 Long-term interest rates

Source: OECD

Figure 5.7 shows the effective index of the real exchange rate of the four selected countries in 2007-2010. The exchange rate of the currencies of the UK and Sweden depreciated in 2008 and 2009, while in 2010 there was an appreciation of the exchange rate in Sweden and in the UK it remains the same as the previous year. As the effective rate of exchange not only takes into account the nominal exchange rate but also the variation in prices, values of Greece and Spain differ, though by very little, because they share the same currency. In contrast to the UK and Sweden, Greece and Spain showed a real appreciation of the exchange rate in 2008 and 2009, while in 2010 there was a depreciation, but the values of these countries for 2010 were very similar to those of 2007. Both currencies of the UK and Sweden suffered depreciation with respect to their main trading partners during the global financial crisis, while the opposite trend was shown in the case of Spain and Greece. The currencies of the UK and Sweden were depreciated in 2008 and 2009, which allowed these countries to deal with the global financial crisis with more competitive exports. The results of the GDP and the unemployment rate show that the strategy of currency devaluation had been favorable for the UK and Sweden, because although these countries experienced a fall of

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GDP in 2009, their recovery had been better than in Spain and Greece, in addition to the increase in unemployment, which had been less pronounced. Figure 5.7 Effective exchange rate index

Source: OECD

The economic effects of the global financial crisis have affected Spain and Greece more than the UK and Sweden. The reason for this is that the monetary and exchange rate policies implemented by the BoE and the Riksbank have been more effective in the UK and Sweden than those implemented by the ECB in Spain and Greece. However, monetary and exchange policies are implemented by the ECB for the whole euro area, where the results have been different, because the unemployment rate is at levels just above 10%, and after the fall of production, there has been on-going economic recovery higher than in Spain and Greece. Financial markets have influenced the behavior of long-term interest rates in countries like Greece and Spain, however, such behavior is not only based on economic fundamentals, because Spain and the UK had similar levels of public debt and deficit, but the long-term interest rates had been greater for Spain since the beginning of the global financial crisis. This shows that there

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was a lack of an economic governance mechanism that controls the markets’ unfounded instincts, and in spite of the measures taken in 2012 by the ECB, the economic development of Spain and Greece is very limited. Conclusions The aim of this paper was to show whether the economic governance of the area was enough for Spain and Greece during the global financial crisis. To achieve this, we analyzed the measures taken by the European institutions and the economic performance of Spain and Greece. Furthermore, we compared these problematic countries with the UK and Sweden, which have autonomous monetary policies. The comparison is based on the fact that while Spain and Greece gave up their monetary policy, the UK and Sweden continue to maintain their monetary policies, so that it is possible to analyze the behavior of the ECB, the BoE and the Riksbank. On the other hand, the four countries share the single market rules, because they are part of the EU. The global financial crisis was felt in Europe since the end of 2008, but it was in 2009 when major falls in production ensued in almost all European countries. The main economic consequence of the crisis was a drop in GDP and an increase in the unemployment rate in Europe; however, the effects were different among European countries. Although some domestic factors in Spain and Greece further aggravated the crisis in these countries, European economic governance also affected the peripheral countries. The theory of OCA points out the conditions that countries must have to be able to integrate monetarily and cede their monetary policy to a supranational central bank. Studies show that the euro area is not an OCA, and that Spain, Greece, Sweden and the UK do not qualify for sharing a common currency with the euro area countries. The UK and Sweden decided not to use the euro for different reasons, while Spain and Greece took the decision to be part of the euro area, to import the ECB's economic stability. The UK and Sweden took another approach, granted more independence to their central banks and adopted a strategy of inflation targeting. Thus, the international financial crisis faced these two groups of countries differently, because Spain and Greece depended on the measures taken by the ECB, while the UK and Sweden have autonomous central banks. The economic governance of the euro area before the crisis was based on the SGP, the ECB and the euro-group. With the global financial crisis, institutions had to take extraordinary measures. The European institutions had to create rescue funds for countries like Greece, Portugal, Ireland, Spain and Cyprus, and strengthened mutual monitoring mechanisms for members of

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the euro area that would not make excessive deficits to put at risk the rest of the countries sharing the euro. The risk premium continued to rise in the peripheral European countries, and it was until September 2012, when the President of the ECB said that this central bank would be willing to buy unlimited amounts of sovereign debt in the secondary markets in case of need, reducing the risk premium in the following months. The strategy taken by the ECB was different to those taken by the BoE and the Riksbank. At the start of the global financial crisis, all three central banks reduced short-term interest rates, in addition to increased liquidity in their economies through various measures. However, while the BoE and the Riksbank implemented QE, the ECB sterilized programs to support the financial sector. On the other hand, the exchange rate in the UK and Sweden depreciated in 2009 and 2010, while the euro appreciated in that period. The economic effects of the global financial crisis were completely different in the UK and Sweden compared to Spain and Greece. The fall of GDP in Spain and Greece was much higher than in the UK and Sweden, in addition to the unemployment rate of the first group of countries that reached levels above 25% in 2013, while in the second group of countries their unemployment rates were below 8%. Nevertheless, Sweden and the UK had much stronger public finances than Greece, and a lesser real estate bubble than Spain. Greece's public debt had been at levels of 100% (% GDP), with the global financial crisis Greek debt reached 180% (%GDP). The UK and Spain had precrisis levels of public debt of 40% (% GDP) and the crisis level that reached 100%. Sweden shows a downward trend in public debt, which did not change with the global financial crisis. Although the behavior of public deficits in the UK and Spain were very similar before and after the global financial crisis, long-term interest rates of both countries are different. This situation shows that not only internal factors counted in the economic effects of the global financial crisis, but also influenced aspects of economic governance in the euro area. The theory of the OCA shows that countries like Spain and Greece should not use the euro, however, the costs to stop using national currencies are significantly reduced with good economic governance. The effects of the global financial crisis were felt more in Spain and Greece than in Sweden and the UK, due to internal factors, but also to the economic governance of the euro area and the different management of monetary policy of the BoE and the Riksbank in relation to the ECB.

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References Alesina, A., Barro, R., & Teneyro, S., 2003. Optimum Currency Areas. In: M. Gertler & K. Rogoff, eds. 2003. NBER Macroeconomics Annual 2002. Cambrige: The MIT Press. De Grauwe, P., 1993. The Political Economy of Monetary Union in Europe. The World Economy, 16(6), pp. 653–661. De Grauwe, P., 2006. On Monetary and Political Union. Leuven: University of Leuven. De Grauwe, P., 2007. The Economics of Monetary Integration, Seventh Edition. Oxford: University Press. De Grauwe, P., 2011. The governance of a fragile Eurozone. CEPS Working Document, No. 346. Dellas, H., & Tavlas, G. S., 2001. Lessons of the euro for dollarization: Analytic and political economy perspectives, Journal of Policy Modeling, 23(3), pp. 333-345. Eijffinger, S., & Hoogduin, L., 2012. The ECB in (the) Crisis. DSF Policy Paper, 22. Frankel, J. A., y Rose, A. K., 2002. An Estimate of the Effect of Common Currencies on Trade and Income, Quarterly Journal of Economics, 117(2), pp. 437-466. Frankel, J. A., y Rose, A. K., 1998. The Endogeneity of the Optimum Currency Area Criteria. Economic Journal, Royal Economic Society, 108(449), pp. 1009-1025. Herzog, B., & Hengstermann, K., 2013. Restoring Credible Economic Governance to the Eurozone. Economic affairs, 33(1), pp. 2-17. Kenen, P. B., 1969. The Optimum Currency Area: An Eclectic View, Monetary Problems of the International Economy. In: R. A. Mundell, & A. K. Swoboda, eds. Monetary Problems of the International Economy. Chicago: University of Chicago Press. pp. 41-60 McCallum, B. T., 1995. Two Fallacies Concerning Central-Bank Independence, American Economic Review, 85(2), pp. 207-211. McKinnon, R. I., 1963. Optimum Currency Areas, The American Economic Review, 53(4), pp. 717-725. Mundell, R. A., 1963. A Theory of Optimum Currency Areas, The American Economic Review, 51( 4), pp. 657-665. Pomfret, R., 2005. Currency Areas in Theory and Practice, The Economic Record, 81(253) pp. 166-176. Tavlas, G. S., 1993. The ‘New’ Theory of Optimum Currency Areas. The World Economy, 16(6), pp. 653–757. Tavlas, G., 1994. The theory of monetary integration, Open Economies Review, 5(2), pp. 211-230.

6

Economic and political impacts of the global financial crisis in

the autonomous communities of

Spain

Introduction The global financial crisis of 2008 and the sovereign debt crisis of 2010 have differentially affected European countries in economic and political aspects. While countries like Germany, the Netherlands and Finland were hit by the global financial crisis, the sovereign debt crisis did not significantly affect them because their bonds have high credit ratings. Countries such as Greece, Ireland, Portugal and Spain were affected by the global financial crisis and also by the sovereign debt crisis due to their high levels of public deficit and public debt. These countries score low in rating agencies and were rescued by the European institutions and the IMF. The bailouts were conditioned to austerity measures that governments should implement, under the supervision of the Troika (ECB, European Commission and IMF). The bailouts caused a drop in GDP, because it required raising taxes and cutting public spending. In addition, unemployment rates increased significantly, including extreme cases found in Spain and Greece, where the unemployment rate reported levels above 20%. The economic downturn affected governments during the crisis, which had led to changes of government. In the case of Spain, it moved from a center-left government to center-right government, while in the case of Greece moved from a center-left government to a technical government and finally to a coalition government led by a centerright party. European citizens have suffered the consequences generated from the international financial crisis and sovereign debt crisis, among others. The economic and political decisions and measures of their respective ruling governments have had important repercussions in their lifestyle. In Spain, social movements that protest and demonstrate against the crisis have increased in number and strength (e.g. 15-M Movement and Democracia Real 129

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YA). A common trait found in these movements is that they share a strong rejection against Spanish politicians and the current two-party system in Spain (Partido Socialista and Partido Popular). There is a political crisis in Spain highlighted by the results in the elections and corruption scandals that took place at the different levels. The economic effects of the global financial crisis at the autonomous community level were the increase of the unemployment rate and a considerable GDP reduction. At regional level the effects were more severe than at the national level. There were Autonomous Communities with unemployment rates above 30%. Eight autonomous communities are among the ten European regions (NUTS level 2) with the highest unemployment rates. Andalusia is the second European region (NUTS 2) in 2012 with the highest unemployment rate (34.6%). This situation is complicated because Andalusia is the largest region in Spain with a population of more than 8 million. There is a convergence in the unemployment rate in the Spanish autonomous communities since the global financial crisis began because of the generalized increase in the unemployment rate. However, the same was not true at the European level because there was a divergence. The convergence at the Spanish regional level is a convergence in “misery” because the autonomous communities were converging towards a worse scenario. If we use the GDP at the Spanish regional level, since the international financial crisis there is a divergence. The GDP among the autonomous communities increased with the global financial crisis. The difference between the GDP divergence and the convergence in “misery” in the unemployment rate was due to the fact that the employment rate plunged and it was generalized in all the autonomous communities while the GDP reduction was softer and differentiated by region. Economic and political impacts of the global financial crisis and sovereign debt have been studied for countries of the EU, and in particular for countries that have been bailed out. However, in the regions of these countries differentiated impacts can be observed and in some cases even higher than the national average. The aim of this paper was to analyze the economic and political impacts of the global financial crisis in the regions of Spain. The regional analysis focused on the Spanish autonomous communities, in areas such as unemployment rate, public debt, GDP, regional bailouts, elections and changes of government of the communities. The analysis was from the global financial crisis to 2013.

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Regional effects of the global financial crisis The global financial crisis and its effects on unemployment and economic growth The global financial crisis started in the US with the crisis of sub-prime mortgages because high-risk clients were granted mortgage loans. Several commercial banks in the US had to be rescued by the government. Consequently, the crisis affected most of the world's stock exchanges. In Europe, the crisis began in 2008 because there was a credit crunch that affected the real economy. In 2009, the credit crunch caused a reduction in economic activity in the European countries with sharp declines of GDP. The European governments responded with the provision of liquidity by central banks, and in some cases with economic recovery programs. Additionally, the ECB cut back the interest rates to historic levels to stimulate the lending and investment in order to mitigate the effects of the global financial crisis. In late 2009, the former Greek Prime Minister, George Papandreou, said that the deficit and public debt of Greece would be higher than those that had been estimated by the previous government, which alerted international investors about the possibility that Greece would not have enough liquidity to cover the payments on short-term bonds. After the first months of 2010, the risk premium increased, and in May 2010, Greece had to be rescued. As a result, Greek bonds were regarded as "junk bonds" by the rating agencies. Several countries had the same result as Greece. Ireland, Portugal, Spain and Cyprus had to be bailed in the following years by the European institutions. The sovereign debt crisis (2010-2012) was characterized by high-risk premiums due to the high levels of public deficits. Bailout funds were created to rescue European countries. The President of the ECB, Mario Draghi, announced in September 2012 that the ECB would be willing to buy unlimited amounts of government bonds in the secondary market in order to reduce the risk premium. The effects on the members of the EU have been diverse, because in some cases the fall in economic activity and rising unemployment have been reduced, while in other countries the effects of the crisis have been severe. The global financial crisis has had two main effects on EU countries: The first has been a fall of the GDP, and the second is an increase in the unemployment rate. Spain has been one of the most affected countries by the global financial crisis, both in the fall of its GDP and in the increase of its unemployment rate. Before the global financial crisis, the economic growth rate in Spain was higher than the average of the EU countries (Figure 6.1), in 2009;

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both Spain and the EU had a fall of the GDP close to 4%. However, since 2010 Spain had grown to levels below those of the EU, so that there was economic divergence between Spain and the EU countries. Figure 6.1 Economic growth: Spain and the European Union

Source: Eurostat

With regards to unemployment, Spain has had an unemployment rate higher than the average of the EU. However, since 2000 there was a convergence in the unemployment rate until 2007 (Figure 6.2). Since 2008, the unemployment rate in Spain began to grow faster than the EU average, which caused divergence, and by early 2013 there was a difference of almost 16 points between the unemployment rate of Spain and the EU.

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Figure 6.2 Unemployment rate: Spain and the European Union

Source: Eurostat

At the NUTS 2 level, Spanish regions had also suffered the global financial crisis. In 2001 they were not among the 10 NUTS 2 with the highest unemployment rates in the EU, while in 2012 there were eight autonomous Spanish communities at the top of the list (Table 6.1). The previous situation showed that the global financial crisis led to divergence between Spanish regions and other regions of the EU, which had reduced living standards in several Spanish regions. Autonomous city of Ceuta (38.5%), Andalusia (34.6%), Extremadura (33%), and the Canary Islands (33%), were the only regions in the EU with unemployment rates greater than 30%.

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Table 6.1 Regions (NUTS 2) with the highest unemployment rate in the European Union 27 NUTS 2 Reunion (FRANCE) Severozapaden (BULGARIA) Guiana (FRANCE) Yugoiztochen (BULGARIA) Guadeloupe (FRANCE) Calabria (ITALY) Eastern Slovakia (SLOVAKIA) Lower Silesia Province (POLAND) Martinique (FRANCE) Lubuskie Province (POLAND) European Union NUTS 2

2001 31.5 29.8 28.1 25.4 25.2 25 24.4 24.1 24 23.4 8.72

NUTS 2 Ceuta (SPAIN) Andalusia (SPAIN) Extremadura (SPAIN) Canary Islands (SPAIN) Melilla (SPAIN) Reunion (FRANCE) Castile-la Mancha (SPAIN) Region of Murcia (SPAIN) Central Greece (GREECE) Valencia (SPAIN) European Union NUTS 2

2012 38.5 34.6 33 33 28.6 28.6 28.5 27.9 27.8 27.7 10.5

Source: Eurostat

The effect of the global financial crisis was greater on the regional level than on the national level, because in some Spanish regions the unemployment rate was higher than in Spain. The country with the highest unemployment rate in the EU was Spain (27.2%); however, there were eight Spanish regions with higher unemployment rates. The second region (NUTS 2) of the EU with the highest unemployment rate in 2012 was Andalusia (34.6%), which has a population greater than 8 million people. Andalusia's population is greater than that of 13 EU countries (Table 6.2), so that unemployment in that region may be greater than or equal to the previous countries. Regional imbalances that caused the global financial crisis have had severe implications for regions as large as Andalusia, which required economic recovery programs to reduce the unemployment rate. Table 6.2 Countries in the European Union 27 with smaller population than Andalusia, 2012 Country/ Region Inhabitants Andalusia 8,449,985 Austria 8,443,018 Bulgaria 7,327,224 Denmark 5,580,516 Slovakia 5,404,322

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Finland 5,401,267 Ireland 4,582,769 Lithuania 3,007,758 Slovenia 2,055,496 Latvia 2,041,763 Estonia 1,339,662 Cyprus 862,011 Luxembourg 524,853 Malta 417,520 Source: INE and Eurostat

Theoretical explanations of regional economic differences The issue of unemployment has been more studied at the national level than the regional level, because at the regional level it is more difficult to get statistical data, meaning that such studies have not been very frequent (Demidova and Signorelli, 2011). On the other hand, the OECD (2011) showed that differences in the regions in countries are greater than those among countries, so it is important to analyze at regional level. There are many variables that explain the different levels of unemployment across countries, which include: the benefits (and duration) of unemployment, labor market policies, the degree of coordination, the degree of centralization, and the tax wedge (Feldmann, 2009). Marelli, Patulli and Signorelli (2012) explained that the main European regions affected by the global financial crisis were those specialized in the construction sector. However, at the beginning of the crisis regions that specialized in manufacturing were also affected due to the effect of declining exports. The effect was greater in regions that specialized in construction (Spanish regions), because of the links between the construction sector and the banking sector. When the credit was reduced, there was no money to fund the sector causing many people to lose their jobs, so mortgages could no longer be paid. While in regions that specialized in manufacturing the effect was temporary, because exports increased again in 2010, so these regions have begun to recover. The economic convergence has been studied since the nineties (Barro, 1991; Barro and Sala-i-Martin, 1992 and Sala-i-Martin, 1997) to analyze whether the differences in GDP per capita among a group of countries (regions) were reduced. Several other studies have used the unemployment rate to test if there is economic convergence. Fallahi & Rodriguez (2011) found that there was economic convergence among the unemployment rates of the Canadian

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provinces. Bayer & Juessen (2007) found convergence of unemployment rates for West German regions. The existence of beta-convergence and sigma-convergence can be estimated: beta-convergence is obtained if the countries (regions) with higher per capita incomes are growing at a lower level than the countries (regions) with lower income per person, or if countries (regions) with higher unemployment rates are reducing unemployment faster than countries (regions) with lower unemployment rates. Sigma-convergence is obtained if there is a reduction of the dispersion (standard deviation or the coefficient of variation). The European Commission (2012) noted that the global financial crisis has led to divergence in unemployment rates between the countries of northern and southern of Europe: Labor markets have continued to be marred by increasing divergence among member states, whilst the average EU unemployment rate exceeded the 10% mark earlier this year …. Divergence in the EU-27 and especially between the north and south of the euro area has never been so significant .… the picture for individual member states is varied (European Commission, 2012: p. 17). One of the main effects of the global financial crisis was the increase in the divergence in unemployment rates among European countries. However, regionally the results change. Blazek and Netrdová (2012), using NUTS 3, found convergence in unemployment rates among new member states of the EU (Central and Eastern Europe), although the authors note that this convergence is a convergence in “misery", i.e. unemployment rates in regions of these countries are converging but on the rise. The scenario is convergence in “misery", because even though there is less dispersion in the economic development, this is one scenario where regions are getting worse. Regions in Spain: main facts There are three levels of territorial power in the Spanish system of government: State, the autonomous communities and the local entities. The autonomous communities are a political and administrative division of Spain. There are 15 autonomous communities in Spain that are located in the mainland: Andalusia, Aragon, Principality of Asturias, Basque Country, Cantabria, Castile-La Mancha, Castile and Leon, Catalonia, Community of Madrid, Extremadura, Galicia, La Rioja, Region of Murcia, Navarre and Valencian Community. Two islands: Balearic (located in the Mediterranean Sea) and Canary Islands (an archipelago located off the coast of Morocco in the Atlantic Ocean). There are two Spanish autonomous cities located in the Maghreb,

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Ceuta and Melilla. The closest levels of government to citizens are the local entities, such as municipalities, provinces, islands and “comarcas”, among others. To date there are 50 provinces and 8,116 municipalities in Spain. According to article 3 of the Spanish Constitution: Castilian is the official Spanish language of the state. All Spaniards have the duty to know and the right to use it. The other Spanish languages shall also be official in the respective self-governing communities in accordance with their statutes. The wealth of the different linguistic forms of Spain is a cultural heritage, which shall be especially respected and protected. This self-governing model set in the Spanish Constitution has since then evolved. The continuous demands for autonomy and recentralization have created frictions in the Spanish multi-level governance and in some cases they have become the main issue of competition between the major political parties. Catalonia and the Balearic Islands have Catalan as an official language in their region. Valencian Community has Valencia, Basque Country and Navarra have Basque and Galicia has Galician. In addition to the national capital, the city of Madrid, each autonomous community has a capital. For example, the capital of Catalonia is Barcelona and the capital of Basque Country is Vitoria-Gasteiz. Within each autonomous community there may be more than one province (e.g. Catalonia consists of 4 provinces: Barcelona, Gerona, Lerida and Tarragona). Andalusia, Catalonia, Madrid, Valencian Community and Galicia are the autonomous communities with most population in 2011 (see Figure 6.3). Among the autonomous communities that present a higher percentage of GDP in 2011 are: Andalusia, Catalonia, Madrid, Valencian Community and Basque Country (see Figure 6.4).

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Figure 6.3 Spanish autonomous communities and cities by population 2011

Source: INE

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Figure 6.4 Percentage of GDP of Spanish autonomous communities and cities 2011

Source: INE

The Basque Country and Catalonia are among the most autonomous regions with their own parliament, police force, education system, and collect their own taxes (reduced right, just some taxes). They also have their own electoral cycles for regional elections. For many years, in both autonomous communities separatist and pro-independence groups have been pushing for secession from Spain. Immigrants have settled in Catalonia in the last decades, most of them from Latin America, Africa, Asia and Eastern Europe whereas immigration to the Basque Country is mainly from South America. Catalonia and Basque Country are two of Spain’s richest and highly industrialized regions. Extremadura and Cantabria are among the poorest autonomous communities in Spain with high unemployment rates. There are major disparities among the different regions in Spain.

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Political effects in the Spanish autonomous communities On May 22nd, 2011 thirteen Spanish autonomous communities and two cities held elections. Andalusia, Basque Country, Catalonia and Galicia have different electoral cycles. First we will compare the 2007 with the 2011 regional elections results. Next, we will review the results of the remaining Spanish autonomous communities. There are two main parties in Spain: the PP a mainstream center-right conservative, catholic and economically liberal party, and the PSOE a mainstream center-left social democratic party. Both parties compete for the same electorate, they have gradually moved to the center over the years (Casal, Ferrín & Pardos-Prado, 2010). In the 2011 regional elections PP won a clear victory (see Table 6.3) while PSOE suffered a huge loss. PSOE was defeated in every region that was up for election and the municipalities of Barcelona and Seville, which they had ruled for 28 years. Table 6.3 2007 and 2011 regional elections in 13 Spanish autonomous communities and 2 cities by winning political party and number of seats obtained AUTONOMOUS COMMUNITY ARAGON

BALEARIC ISLANDS CANARY ISLANDS CANTABRIA

CASTILE AND LEON

CASTILE-LA MANCHA CEUTA

EXTREMADURA LA RIOJA MADRID

MELILLA MURCIA

NAVARRE

COMMUNITY

TOTAL

NUMBER

OF SEATS 67

59

60 39

84 49

25

65 33

129 25

45 50

2007 ELECTION

Political Party

PSOE PP

PSOE PP PP

PSOE PP

PSOE PP PP PP PP UPN

Number of seats 30 28 24 17

48 26 19

38 17

67 15

29 22

2011 ELECTION

Political Party PP PP PP PP PP PP PP PP PP PP PP PP UPN

Number of seats

% of votes

35

46.37

20

46.12

25

48.13

30 21

53

39.72

31.91

51.63

18

65.20

20

51.87

32

72 15

46.19 51.74

53.93

33

58.82

19

34.50

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PRINCIPALITY OF ASTURIAS

45

PSOE

21

FAC

16

29.75

COMMUNITY

99

PP

54

PP

55

48.63

VALENCIAN

PP: Partido Popular; PSOE: Partido Socialista Obrero Español; UPN: Unión del Pueblo Navarro; FAC: Foro de Ciudadanos. Source: Autonomous Communities and Ministry of Interior available at http://resultadoselecciones.rtve.es/autonomicas-municipales/2011/autonomicas-municipales (last accessed on June 9, 2013).

In 2012, the regional elections were held in Andalusia, Basque Country, Catalonia and Galicia. In Andalusia the elections were held to renovate the 109 parliamentary seats and elect the regional government. The PP won 40.67% of the votes with 50 seats and the PSOE was in second place with 39.56% of the votes and 47 seats. The defeat was especially painful for the PSOE but was able to form a coalition with Izquierda Unida Los Verdes-Convocatoria por Andalucía (IULV-CA) who managed to obtain 12 seats in this election. The PP was short 5 seats to obtain the absolute majority that would have enabled Javier Arenas to govern the region. José Antonio Griñán (PSOE) with the left coalition was able to govern the region. The Basque Country elections were held in 2012, PNV (Basque National Party) was able to obtain 27 seats of the 75 available and 34.64% of the votes. In second place EH BILDU with 21 seats and 25% of the votes. PSE-EE had 16 seats and 19.13% of the votes and PP 10 seats and 11.73%. UPYD obtained 1 seat and 1.94% of the votes. Iñigo Urkullu (PNV), Lehendakari of Euskadi (President of the Basque Country) who replaced Patxi López (PSE-EE), heads the Basque government. The government of Catalonia had been negotiating for more fiscal autonomy for the region. A motion to call for a referendum about the independence of Catalonia was voted in September 2012. A few months later in the regional elections the CiU won 50 seats and 30.70% of the votes followed by ERC-Cat Sí with 21 seats and 13.70% of the votes. In third place PSC with 20 seats and 14.43% of the votes and PP in fourth place with 19 seats and 12.97% of the votes. Three other parties obtained seats: ICV-EUiA 13, C’s 9 and CUPAlternativa d’Esquerres 3. Even though the CiU obtained the majority of seats it lost 12 compared to the 2010 election where it obtained 38.43% of the votes. In Galicia anticipated regional elections were held and coincided on the same date as the elections held in the Basque Country. The PP won 41 of the

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75 available seats with 45.72% of the votes followed by PSDEG with 18 seats and 20.53% of the votes; AGE obtained 9 seats and BNG 7. Before the elections, many protests and demonstrations were held across Spain. High unemployment and a sluggish economy are among the main reasons Spaniards not only protested but also punished the ruling party at the time (PSOE) in the regional elections, considered by many experts an omen for what would eventually occur in the 2012 national elections. Juventud sin Futuro (Youth without a future), a student group demonstrated in Madrid 2011. A month later, the 15-M movement began on May 15, 2011 with a series of protests across different Spanish cities. This movement is against: unemployment, Spanish politicians, the political system in Spain (two-party, PP and PSOE), capitalism and corruption, among other issues. According to RTVE (Spanish public broadcasting company) between 6 and 8.5 million Spaniards have participated in some way with the 15-M movement, either by participating in assemblies or attending demonstrations. The information and communication technologies played an important role in these demonstrations. Social networks, forums and web pages were actively used to promote and inform about the 15-M movement. A call for demonstrations was launched via Twitter and Facebook to take place on May 15, 2011 in different cities across Spain. Since then, the movement has grown in social networks and public demonstrations. The majority of Spaniards support the movement. Similar protests took place in other European countries as part of a global day of action. These and other protests can be considered a sort of pulse of how disgruntled citizens are with the ruling parties and their measures. Concerning the European elections there is non-European character of the issues. In other words, citizens and political parties are more focused on national problems relegating the European elections. During the 2009 European election in Spain, one of the most important issues was the management of the economic and financial crisis. According to Casal, Ferrín & Pardos-Prado (2010), in spite of the low turnout (46%) the EP elections confirm the ‘bipartidism’ in Spanish politics as the two main parties (PP and PSOE) continue to control more than 80% of the vote (see Table 6.4). The difference with smaller parties is overwhelming, only four of them (CpE, IU-ICV-EUIA-BA, UPyD and EdPV) were able to win seats.

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Table 6.4 2009 European elections summary table of results in Spain POLITICAL PERCENTAGE PARTY PP

PSOE CpE

IU-ICV-

EUIA-BA

OF VOTES 42.23 38.51 5.12

23

2

21

2.5

1

1

0.15

4.89 100

1 0 0

50

23

21

GUE-

ECR NGL EFD NA

2 1

Libertas TOTAL

21

EFA

2

2.87

Others

23

GREENS/

3.73

UPyD

EdP-V

SEATS EPP S&D ALDE

2

2

1

0

1

1

0

1

PP: Partido Popular; PSOE: Partido Socialista Obrero Español; CpE: Coalición por Europea (Partido Nacionalista Vasco, Convergencia I Unió, Coalición Canaria, Bloque Nacionalista Valenciano, Partido Andalucista, Unio Mallorquina); IU-ICV-EUIA-BA: Izquierda UnidaIniciativa per Catalunya Verdes-Esquerra Unida I Alternativa-gloque por Asturies: la izquierda; UPyD: Unión, Progresso y Democracia EdP-V: Europa de los Pueblos-Los Verdes (Eusko Alkartsuna, Los Verdes, Aralar, Bloque Nacionalista Galego (BNG), Esquerra Republicana de Catalunya, Chunta Aragoneista); Libertas: Libertas-Ciudadanos de España. Source: European Parliament available at: http://www.europarl.europa.eu/aboutparliament/ en/00082fcd21/Results-by-country-(2009).html?tab=09#result_group (last accessed on June 9, 2013).

Economic effects in the Spanish autonomous communities The economic effects of the global financial crisis in the Spanish autonomous communities With regards to unemployment, there has been an increase in the unemployment rate in all the autonomous communities. However, the increases have been diverse. Figure 6.5 shows the coefficient of variation of the unemployment rate of the Spanish autonomous communities. Before the global financial crisis there was stability, however, from the third quarter of 2007 to 2010 there was a convergence in unemployment rates, and from 2010 to 2012 the coefficient of variation stabilizes. The convergence period in unemployment

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rates of the Spanish autonomous communities coincided with the worst of the global financial crisis (2009), however, this period was characterized as a convergence in “misery", because all the communities converge but on the rise. The decrease of the coefficient of variation and the subsequent stabilization was due to the increase in the average unemployment rate being greater than the standard deviation of the communities. If we use the standard deviation, there would be a continuous increase in the dispersion of unemployment rates since the beginning of the global financial crisis. Figure 6.5 Coefficient of variation of unemployment rate of Spanish communities

Source: INE

We calculated the coefficient of variation of GDP per capita of the Spanish autonomous communities, and the results are different from those obtained with the unemployment rate. The coefficient of variation of GDP per capita increased steadily from 2008 to 2012 (Figure 6.6). There is a process of economic divergence among Spanish autonomous communities. The different results of the coefficient of variation of the unemployment rate and GDP per capita can be explained because the global financial crisis affected unemployment more than the GDP, and the change in unemployment affected all

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145

autonomous communities while the effects of the GDP have been differentiated. If we use the standard deviation the results are not changed because there is a continuous increase of the dispersion. Figure 6.6 Coefficient of variation of GDP per capita of Spanish communities

Source: INE

We analyzed the effects of the global financial crisis on the level of economic sectors in the employment of Spanish autonomous communities. We analyzed four sectors, which are very important to Spain: manufacturing, construction, hospitality and the public sector. The manufacturing sector, which is characterized by the concentration of exports, had a steady fall in employment since 2008 until 2010 (Figure 6.7), this was due to the decreased demand for Spanish exports, as a consequence to the fall in the economic activity in 2009. In 2011, some communities had an increase in employment in this sector that does not offset declines in previous years, with the Community of Andalusia with the biggest drop, because in 2011 the employment in this community represents only 77.4% in relation to 2008. The community with the highest recovery is Navarre.

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Figure 6.7 Changes in employment in manufacturing sector in the Spanish communities

Source: INE

The construction sector has been the hardest hit in Spain. In that sector, the housing bubble that burst out with the global financial crisis was generated. This led to a decrease in the construction of new houses. All communities reported a steady decline in employment from 2008 to 2011; however, the Valencian community had been the most affected, because in 2011 only half of workers continued working compared to 2008 (Figure 6.8) while Ceuta (71.4%) was the least affected community.  

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Figure 6.8 Changes in the employment in construction sector in the Spanish communities

Source: INE

Hospitality is another sector of great importance to the Spanish economy. Many international tourists travel to Spain. In addition, there is a great infrastructure in this sector. All Spanish communities had a loss of employment in 2010 compared to 2008. Due to the global financial crisis, there was a decline in international tourism in 2009 and 2010. The fall of employment in the hospitality sector is moderate in relation to the other sectors (Figure 6.9). Asturias has the highest percentage of employment loss, while the communities of Madrid and Extremadura registered the least loss of employment (97%).  

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Figure 6.9 Changes in the employment in hospitality sector in the Spanish communities

Source: INE

Figure 6.10 shows public sector employment in the Spanish autonomous community from 2008 to 2011. This sector, unlike the three previous sectors, had an increase in almost all communities, with the exception of the Canary Islands and Cantabria, but the decrease is marginal (1.2%). The rise in employment in the public sector is due to the measures that have been taken at the community level to mitigate the effects of the global financial crisis.  

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Figure 6.10 Changes in the employment in public sector in the Spanish communities

Source: INE

Finally, we showed the coefficient of variation of the unemployment rate of the EU NUTS 2 and Spanish communities. The coefficient of variation of the EU is higher than the one of the Spanish communities due to the statistical effect of including more regions, however, trends can be analyzed. Figure 6.11 shows that in the case of the EU there was a convergence in unemployment rates from 2001 to 2007. In the case of Spanish autonomous communities, from 2003 to 2007 there was a process of divergence in unemployment, and from that year on began a process of convergence, but it is a convergence in “misery" because the unemployment rates rose in all communities.  

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Figure 6.11 Coefficient of variation of the unemployment rate

Source: INE and Eurostat

The economic effects of the global financial crisis at the regional level in Spain were different from the rest of the EU, because there was a convergence in “misery" in Spanish regions. This process generated an increase in unemployment in all regions of Spain; while in the case of the EU there was a great difference in the effects received in the regions (NUTS 2). The regions of Spain with the largest increases in unemployment rates are clustered geographically. Andalusia had the highest increase (22.63), followed by Castile-La Mancha (21.93), Canary Islands (2145), Murcia (21.33) and the Valencian community (19.06) (table 6.5). Apart from the Canary Islands, previous communities are clustered in southern Spain and three of them are on the Mediterranean coast, where construction sector activity grew at very high rates during the 10 years prior to the beginning of the global financial crisis.

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Table 6.5 Changes in unemployment rate Autonomous community Andalusia

Castile - La Mancha Canary Islands

2005-2013 (points) 22.63 21.93

21.45

Region of Murcia

21.33

Ceuta

18.43

Balearic Islands

17.95

Valencian Community Extremadura Catalonia

19.06

18.15

16.60

Aragon

16.22

Asturias

14.04

Melilla

Navarre

14.35

12.72

Castile and Leon

12.60

La Rioja

11.69

Community of Madrid Galicia

Cantabria

Basque Country

12.07

11.45 11.15

8.35

Source: INE

Conclusions The global financial crisis had enormous economic and political effects in Europe. There have been several studies that analyzed these effects. Nevertheless, there has been little analysis at the regional level, because regional data take longer to be published than the national data. In addition, research efforts have focused more on the national, and the media have highlighted the economic and political problems that took place in countries like Greece, Spain, Portugal, Ireland and Cyprus. In 2009 there was a drop in production in most European countries and an increase of the unemployment rate. The global financial crisis affected European countries differently, because in some countries the decline in GDP was around 4%, while others had lower falls. In 2010, the global financial crisis turned into a sovereign debt crisis in Europe that affected the peripheral

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European countries, which had to be rescued and implemented with severe austerity measures that affected another fall in production in 2012. Spain has experienced a sharp drop in GDP and the rise to historic levels of unemployment rates, which at the beginning of 2013 is above the 27% and according to the forecasts of the IMF and the OECD will not decrease (significantly) in the following years. At the political level, the global financial crisis caused early elections in late 2011, and the Conservative Party won an absolute majority in parliament, while the governing party obtained minimum levels. The effects of the global financial crisis at the regional level (NUTS 2) in the political and economic spheres have been even graver in some Spanish autonomous communities. However, in the political sphere the effects took a little longer due to the passing period between elections. In the economic sphere, the effects of the crisis became noticeable in 2009, due to increased unemployment, given the vulnerability of the Spanish economic system dependent on the construction sector. The Spanish regional elections are not held at the same time. Although a large majority calls for elections simultaneously, several communities hold elections at other times (e.g. Andalusia, Basque Country, Catalonia and Galicia). The first regional elections, since the beginning of the crisis, occurred in 2009, and since that year have been held until 2012, but it was in 2011 when there were more elections (held simultaneously in 13 autonomous communities). During the administration of former president of the Spanish government, José Luis Rodríguez Zapatero, 16 regional elections were held, of which the PSOE did not win alone, just the exception of the Basque Country in 2009 where in coalition with the PP it won as a first force. The big winner in the elections of 2009-2010 was the PP, because it won 12 regional elections, 11 of which were won as first force. Thus, the political impact of the global financial crisis was that the ruling party, the PSOE, lost the regional elections, while the big winner was the PP, which in late 2011 won the national elections. During 2012, five regional elections were held, in which the ruling party (PP) won only one election, the PSOE won two and the regional parties two. The preferences of the PP have fallen to historic levels during the tenure of the government of Mariano Rajoy. However, the level of acceptance of the PSOE has not increased, leading in turn to an increase in the preferences for parties like the United Left and Union, Progress and Democracy. Regionally, the global financial crisis has positioned local parties in autonomous communities such as Catalonia, the Basque Country, Canary Islands and Navarre. In the economic sphere, the global financial crisis has led to an increased unemployment rate in all the Spanish autonomous communities, as well some Spanish regions are in the top 10 EU NUTS 2 with higher unemploy-

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ment rates. Another consequence of the global financial crisis is that it has generated a process of convergence in “misery" in the unemployment rate of the Spanish communities, although in the last two years the process has stalled. The most affected sector in the Spanish communities has been the construction sector, because in several Spanish regions the employment in that sector dropped almost 50%, while public employment has increased marginally. The global financial crisis has affected communities clustered in southern Spain, which are characterized for the construction sector as a large proportion of their economies. Communities such as Andalusia, Murcia, Valencia, Extremadura and Castile-La Mancha have high rates of unemployment and are also those that register the largest increases. Such communities are clustered geographically in southern Spain, and contrast with northern communities as the Basque Country, Navarra, Rioja and Galicia, where the effects of the global financial crisis were lower. The global financial crisis has had political and economic effects in Spanish communities. Such effects have been differentiated. In the third quarter of 2013, the lowest unemployment rate in Spanish Communities is at 16%, while the highest is at 38%. The political effects are also differentiated, because there are regions with the same political party in the government (before the global financial crisis), while in other regions there has been a change of the political parties in the government. References Barro, R. J., 1991. Economic growth in a cross section of countries. The quarterly journal of economics, 106(2), pp. 407-443. Barro, R. J., & Sala-i-Martin, X., 1992. Convergence. Journal of political Economy, 100(2), pp.223-251. Bayer, C., & Juessen, F., 2007. Convergence in West German regional unemployment rates. German economic review, 8(4), pp. 510-535. Blažek, J., & Netrdová, P., 2012. Regional unemployment impacts of the global financial crisis in the new member states of the EU in Central and Eastern Europe. European urban and regional studies, 19(1), pp. 42-61. Casal, F., Ferrín, M., & Pardos-Prado, S., 2010. Spain Country Report. In: W. Gagatek ed. The 2009 Elections to the European Parliament: Country Reports. Florence: European University Institute. pp. 165-170. Demidova, O., & Signorelli, M., 2011. The impact of crises on youth unemployment of Russian regions: an empirical analysis. China-USA business review, 10(7), pp. 491-507.

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European Commission, 2012. Employment and social Developments in Europe 2012. Luxembourg: Publications Office of the European Union. Fallahi, F., & Rodríguez, G., 2011. Convergence in the Canadian provinces: evidence using unemployment rates. Pontificia Universidad Católica del Perú. Departamento de Economía, Working papers No. 2011-322. Feldmann, H., 2009. The unemployment effects of labour regulation around the world. Journal of Comparative Economics, 37(1), pp. 76-90 Marelli, E., Patuelli, R., & Signorelli, M., 2012. Regional Unemployment in the EU before and after the Global Crisis. Post-communist economies, 24(2), pp. 155-175. OECD, 2011. OECD Regions at a Glance 2011.Paris: OECD Publishing. DOI: http://dx.doi.org/10.1787/reg_glance-2011-en Sala-i-Martin, X., 1997. I just ran two million regressions. The American Economic Review, 87(2), pp.178-183. The Spanish Constitution of 1978. Available in English at: http://www.congreso.es/portal/page/portal/Congreso/Congreso/Hist_Normas/Norm/ const_espa_texto_ingles_0.pdf

Conclusions

Financial crises usually become economic crises, because the credit crunch has effects on the real economy. Falling production and rising unemployment reduce preferences for the governing party, and the ruling party loses in early elections. Such a situation occurred in Europe, with two differences: the economic crisis was differentiated and political costs of the crisis became more pronounced in the peripheral countries. The euro area is a monetary union but not a fiscal union, which makes it vulnerable to several countries that are part of that area. When a country belonging to a monetary union cannot pay its debts in its own currency, it generates dependence on the rest of its partners. Weak governance in the euro area adds to the previous situation, because institutions were not prepared to deal with financial crises. The effects of the European financial crisis were amplified in countries such as Greece, because the rating agencies increased the risk to its bonds due to falling credit and the Greek public finances. High deficits and public debt of Greece increased risk of Greek bonds, which increased the risk premium and the said country was financially rescued three times by its European partners. The main difference of the European crisis and other crises in the world is that Europe has centralized monetary policy but not fiscal policy, so there is no mechanism that allows for the automatic bailout for countries facing financial problems. The above situation caused vulnerability in peripheral countries because financial agents knew that a possible bailout was not contemplated, since a bailout in the treaties of the EU was forbidden, raising uncertainty about Greece. This weak economic governance of the euro area generated spillover effects in several peripheral European countries, such as, Spain, Portugal, Ireland and Cyprus.

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Bailed out countries had to implement austerity policies demanded by the Troika, which generated rejection towards governments, consequently several changes of government occurred. The electorate of the rescued countries preferred opposition parties, due to the economic and social effects of the austerity policies, and even in Greece, voters voted overwhelmingly for SIRIZA, a party contrary to the austerity policies of the Troika. The euro area is divided into two groups of countries. The first is led by Germany, with economies that have been affected to a lesser extent by the crisis, with high ratings on its bonds and high contributions to the bailout funds, besides they have influence on the conditions of austerity policies imposed by the Troika to the rescued countries. The second group is composed of countries like Greece, Portugal, Spain, Ireland and Cyprus, which have been greatly affected by the crisis, furthermore they have been rescued and have had to implement austerity policies. The European financial crisis has two particular features: 1. The crisis has affected the countries of the euro area differently. A first group of economies was affected in 2009, because there was a reduction in its economic activity, however, since 2010 such economies have grown, and even in Germany the unemployment rate has declined. A second group was affected in 2009, but since 2011 another fall occurred due to the increase of risk premium in peripheral countries. In this second group of countries a “w" crisis occurred, while in the first group of countries the crisis had a form of "u". Countries with an economic downturn since 2011 have implemented austerity policies that have deepened the crisis, because some of the recommendations of the Troika involve reducing public spending and increasing taxes that impact negatively on GDP. The European crisis was experienced differently in European countries, because in some countries the crisis was temporary, while in other countries citizens have had to withstand several years of reduction of social spending. 2. The financial crisis has had economic and political effects. The economic impact has been a decline in production due to the scarcity of credit in 2009, which led to a reduction in GDP in several European countries as well as a drop in exports. Furthermore, in almost all European countries there was an increase in unemployment, the level of the EU and the euro area unemployment rate rose above 10%, high levels compared to pre-crisis years. In the financial sphere, an overall increase in the risk premium on bonds of European countries took place, although it was accentuated in peripheral

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countries due to the effects of the contraction in economic activity on public revenue. Several countries had to be bailed, so financial funds were built with funds from the European countries to carry out rescues. Jointly with the IMF, European institutions created the Troika, to follow up on austerity policies that would reduce the deficit and public debt of the rescued countries. The European financial crisis had political effects in the short term. The decline in economic activity in 2009 led to changes of government in most European countries, because some countries called for early elections and some ruling parties were defeated. In Spain there was a change of government in 2011, with the PSOE leaving government, while in France, the Union for a Popular Movement left office making way for the Socialist Party, in the UK the Labour Party left office and the Conservative Party won, whilst in Germany the Christian Democrats of Angela Merkel has won 2 elections during the crisis. In other countries like Italy and Greece, technical governments were appointed and later were replaced by governments that won early elections. Another political effect of the European financial crisis was the increasing preference of anti-European and anti-austerity policy political parties, such as the National Front in France and the Independence Party in the UK, which received a historic vote in the European Parliament elections in 2015. In other countries, like Spain and Greece, bipartisanship could come to an end as a result of the crisis, because in Spain, according to the latest surveys, most of the electorate is divided into new parties such as Podemos. The triumph of SIRIZA in Greece has generated discussion on the relevance (and effectiveness) of the austerity policies implemented and monitored by the Troika.

Siendo rectora de la Universidad Veracruzana la doctora Sara Ladrón de Guevara, European Financial Crisis: Economic and Political Aspects de Edgar J. Saucedo Acosta y Samantha Rullán se terminó de imprimir en el mes de julio de 2016, en Pastoressa, diseño gráfico, editorial y producción. Agustín Melgar 1, Unidad Veracruzana, CP 91030, Xalapa, Ver., [email protected]ahoo.com.mx. Corrección de estilo: Paul Robinson El tiraje consta de 450 ejemplares. Se usaron tipos Palatino

In this book we analyze, from various perspectives, the European financial crisis. This crisis has impacted on all countries of the European Union, however, peripheral countries have been the most affected, because their unemployment rates have been at very high levels in addition to the spread of bonds that have been considerably high. On the other hand, so far five countries have been bailed out (Spain, Portugal, Greece, Ireland and Cyprus) by European funds that have been created for this purpose, but these countries have had to implement austerity measures requested by the Troika (European Commission, European Central Bank and International Monetary Fund), which has led to changes in government, due to the unpopular economic measures. This book explores the European crisis from an economic and political perspective, from studies that have been done for different application areas, such as: a European level, for countries called “PIGS”, for the European Central Bank, a comparison between countries that use the euro and those that do not use the euro, and among regions of Spain.

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