Much Ado about EMU

Andrew K. RoseBerkeley, Haas

1Andrew Rose , EMU

Understanding the European Crisis

• What are the risks of a European Sovereign Debt Crisis?– Financial Markets: risks non-trivial but low• Currently (4/20) Greek 10-yr bond rate ≈ 13.3%

– Economic and Political Fundamentals remain poor• Recession ended, but growth slow, unemployment high• Syriza elected 1/2015 to end austerity• IMF, EC, Germans seem implacable

– Who’s Right? The Markets or the Fundamentals?

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How can we understand the Euro Crisis?

• What are the underlying causes?– Political, Economic, and Financial

• Are the policy makers and markets correct in their diagnoses?– Probably Not

• What are the potential implications for Europe and the rest of the world?– Potentially disastrous

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Beware Greeks Bearing Bonds

• Sovereign default was inevitable– So far voluntary; “disorderly” to come?

• Current Greek 10-yr bond ≈13% (way down)– German ≈.1% (US, UK, Japan very low too)

• Government Debt unsustainable (≈175% GDP)– German ≈ 75%

• Big government deficits gone now– Greek “primary surplus” before interest

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How Could This Happen?

• Article 103 (“No Bail-Out”) Maastricht Treaty– “… neither the Community nor any Member State

is liable for or can assume the commitments of any other Member State”

• But when push came to shove, spirit of Treaty violated

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Evolving E-Bailout Institutions• European Financial Stabilization Mechanism (EFSM)

– EC funds (from EU budget) of €60 bn• European Financial Stability Facility (EFSF)

– May 2010: to “safeguard financial stability in Europe”– Can issue €440 bn of bonds, guaranteed by members, to lend to members “in

difficulty” who request help, s.t. EC, ECB, IMF (“troika”) conditionality– Greece requested and received rescue package from EU/IMF (€110 bn), May

2010– Ireland and Portugal followed

• European Stability Mechanism (ESM)– Permanent bailout kitty aka “Firewall”– Increased in late March 2012 to €500m, started 7/2012, fully ready by 2014 (!)

– Probably still too small (German objections; France + others wanted €1 tn)– EFSF + ESM limit is €700 bn– Draghi, Sept 2012: ESM approval implies unlimited ECB support, will do “what it takes”

• European Monetary Fund (EMF) started July 2012• Banking Union (ECB at center) started Nov 2014 – single supervisor

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How Did We Get Here?

• Important to Understand Membership

Requirements for EMU

• Five “Convergence Criteria” required for entry

• To be applied by the “Council of Ministers”

• Mostly Economic, but Highly Politicized

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Convergence Criteria, 1

Institutions– Central bank independence– Easy!

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Convergence Criteria, 2

Inflation– CPI inflation within 1.5% of target– Target is average inflation of three countries with

lowest inflation– Still easy!

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Convergence Criteria, 3

Interest Rates– Average long-term interest rates within 2% of

target;– Target is average long-term interest rate of the

three low-inflation countries– Note: some “wiggle-room” for sovereign risk premia

– Again, easy!

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Convergence Criteria, 4

Exchange Rates– Fixed Exchange Rates within “normal bounds”

(15%!)– No realignment within last two years– Once more: easy!

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Convergence Criteria, 5

Fiscal Positions•Members must have “Sustainable Government Financial Position” defined as:

a) Flow: Deficit/GDP ratio of less than 3%, andb) Stock: Debt/GDP ratio of less than 60%– “Escape clauses” exist for “temporary

circumstances” or declining debt•Not so easy!– Most scraped in– Greece lied its way in

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Stability (and Growth) Pact• EMU “Ins” should maintain deficits of less than

3% GDP while in EMU or face penalties – German origins– Implies pro-cyclic fiscal policy (!)

• Widely flouted by large countries in practice– France ‘03-’07, Germany ‘03-’06, Italy ‘03-?– Also breaches by Greece, Netherlands, Portugal– Reformed slightly in 2005– Revived at summit in December 2011, via “Six Pack”

(2011) and surveillance in “Two Pack” (2012)

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Hence More Fiscal Austerity

• Considerable pressure on Greece to maintain/raise taxes, cut spending (after 5-yr recession!)– Portugal, Spain, Ireland too– German View: Roasting the Meat (or Burning it?)

• But … will this work?– The markets aren’t panicked– Most commentators agree with markets

• Right way to approach the problem?Andrew Rose, EMU 14

How Should One Think about EMU?

• Economists (and Haas MBA students) usually

ask two questions on EMU

1. “Do European Countries look like an ‘Optimum

Currency Area’?”

2. “Are European Countries similar to American

Regions?”

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“Optimum Currency Areas”

• Mundell’s Nobel Idea: When are two regions

more likely to gain from common currency?

1. If they share deep trade links and

– Single currency reduces transaction costs of trade

2. If they have similar business cycles

– Same monetary policy appropriate

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But if Two Regions have Asymmetric Business Cycles …

• Need to be able to Adjust to “Asymmetric

Shocks” (good for one region, bad for another)

• Otherwise boom in one region causes inflation

• Recession in other causes unemployment

• Costs of asymmetric business cycles can swamp

(any) trade gains

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One Way to Adjust(to Asymmetric Business Cycles)

• Sharing risks

– System of taxes/transfers

– “Robin Hood” taxes rich, transfers to needy

– Relieves unemployment, inflation

• In principle, can do via private sector (international

cross-holdings of assets)

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An Alternative Adjustment Method

• Factor Mobility

– Unemployed workers move to places of high

demand

– Relieves unemployment and inflation

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Mundell’s “Optimum Currency Area”

1. Suppose business cycles are asymmetric, and2. There is a) little risk-sharing, and b) immobile

labor, then3. Gain from using differential monetary policy to

smooth different shocks• Use different monies to adjust to different business

cycles• Evidence within countries (e.g., American

regions)• Evidence across countries (e.g., EMU)

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Fiscal Austerity is not the Solution

• It solves a different problem• Greek problem is poor competitiveness– Manifestations: current account deficit, slow

growth, unemployment– Also true of other “Club Med” (Portugal …)

• Classic example of “asymmetric shock”

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Competitiveness within EMU

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1999 2005 2008 2009 2010 2011 2012 2013

Real effective exchange rate (2010 = 100)

Germany 101.3 100.0 101.5 102.3 97.3 96.5 93.0 94.5*

Greece 94.5 100.0 105.4 106.9 106.7 107.5 104.1 103.2*

Portugal 92.7 100.0 102.7 102.1 100.0 100.8 99.5 99.8*

Spain 90.9 100.0 106.1 106.3 103.7 104.3 102. 101.2*

Current account balance (% of GDP)

Germany -1.3 5.1 6.2 6.0 6.3 6.2 7.0 8.0*

Greece -5.5 -7.6 -15.0 -11.2 -10.3 -9.9 -3.5 -.7*

Portugal -8.7 -10.3 -12.7 -11.0 -10.0 -7.1 -1.6 -3.0*

Spain -2.9 -7.4 -9.7 -4.8 -4.6 -3.5 -1.1 -1.9*

Unemployment Rate

Germany 8.4 11.1 7.5 7.7 7.1 5.9 5.2 5.1*

Greece 11.7 9.8 7.7 9.5 12.5 17.7 27.6 26.7*

Portugal 4.4 7.6 7.6 9.5 10.8 12.7 15.6 15.3*

Spain 15.6 9.2 11.3 18.0 20.1 21.6 26.0 26.0*

Bottom Line

• Greece has a fiscal problem– But solving it (if possible) won’t restore growth– Difficult to sustaining pro-cyclic fiscal policy

• Real problem: poor competitiveness limits growth, employment (Portugal, Spain too!)– Bubble overhangs also

• No easy solution for that• Hence … more serious crisis inevitable– Could easily be worse than Lehman

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