The Breakup of the Euro Area: A Roundtable

Trobada XBarcelona GSE

October 26, 2012

The Euro and the onset of the crisis

Ever since debt problems first surfaced in Greece, it has been widely believed that a default by a European country, no matter how small, would threaten the existence of the Euro.

To what extent is this view based on sound economics? What are the most important economic links between sovereign defaults in Europe and the sustainability of the common currency?

The Euro and the buildup of the crisis

Many economists claim that the severity of the European crisis is due, at least in part, to the flawed design of the Euro.

Do you agree with this view? Are there institutional aspects of the common currency that have aggravated the crisis? Or is the problem not so much in the institutional design of the Euro per se, but rather in the policies that have been adopted since the onset of the crisis?

The future of the Euro

Is there a future for the common currency? If so, how do you think the system should be reformed going forward? If not, how do you think a breakup will happen? What are the main policy challenges that such a breakup would pose?

•  I"will"talk"about:""

–  Euro"area"heterogeneity"both"in"borrowing"condi6ons"(for"sovereigns,"banks,"firms"and"households)"and"in"the"transmission"channel"of"

monetary"policy ""

•  “Heterogeneous"Transmission"Mechanism:"Monetary"Policy"and"

Financial"Fragility"in"the"Euro"Area,”"(coHauthored"with"MaIeo"

Ciccarelli"and"Angela"Maddaloni,"both"ECB)"

–  Banking"union"

Not"talk"exactly"on"Alberto’s"ques6ons"(more"interes6ng"ones)"nor"on"the"

lack"of"op6mal"currency"area…"(Krugman,"NBER"Macro"Annual,"2012)"

“The%Breakup%of%the%Euro,”%Barcelona GSE Trobada X%%José=Luis%Peydró%%(UPF%and%Barcelona GSE)%

1"

Main%points%Large"heterogeneity"in"borrowing"condi6ons"and"in"the"Euro"area"monetary"

transmission"channel"between"distressed"(PIIGS)"and"other"EA"countries"

"

•  Bank"lending"channel"was"not"key"in"2010H11"(and"2008H09)""

•  But,"given"2012,"without"banking"union"it"is"impossible"to"survive"(notably"

deposit"insurance,"a"Euro"area"TARP"and"banking"supervision)"

–  PIIGS"survive"because"of"the"Eurosystem"liquidity,"but"PIIGS"exposure"is"massively"

increasing"and"runs"on"PIIGS"are"happening"

–  Poli6cal"problems"(moral"hazard"of"TARGET"debtor"and"creditor"countries),"

bargaining"threats,"and"increasing"credit"risk"for"TARGET"creditor"countries"

–  Other:"what"about"current"losses,"retail"runs"vs."wholesale"crossHborder"contagion…"•  The"firm"balance"sheet"channel"is"s6ll"very"important"for"PIIGS"in"2010H11"(also"

in"2008H09)"and"ECB"policies"very"limited"power"to"reduce"credit"fric6ons""

–  ECB"could"buy"sovereign"and"firm"stuff,"but"poli6cal"limita6ons"

–  UK"and"Japanese"alterna6ve"ways"to"increase"credit"supply"for"firms"

–  Debt"overhang"and"deleverage:""e.g."Spain"versus"US"and"Sweden"aber"their"crisis"(high"infla6on,"bankruptcy"code"for"banks,"loans"with"full"recourse,"defaults…)"

2"

1.  A"brief"narra6ve"of"the"crisis"

2.  Standard"monetary"policy"in"a"heterogeneous"context,"the"

amplifica6on"mechanism"of"the"credit"channel"and"the"role"of"nonH

standard"measures"for"the"period"2007H2011"

3.  Back"to"the"main"points"I"wanna"make"and"the"period"2012"

Outline%of%remaining%presentaKon%Outline%

3"

!  Strong"overall"impact"of"the"crisis"on"the"Euro"area"but"with"heterogeneous"

consequences"across"member"countries"

!  Heterogeneity"throughout"the"crisis"in"economic"ac6vity,"in"credit"condi6ons"

and"in"financial"fragility"(of"banks,"nonHfinancial"borrowers"and"sovereign)"

!  A"single"monetary"policy"copes"with"this"heterogeneity"across"member"states"

"  What%are%the%effects%of%the%single%Euro%area%monetary%policy%in%such%heterogeneous%plot?%

MoKvaKon%QuesKon%that%we%address%in%the%paper%

4"

Increased%heterogeneity%of%sovereign%risk%

%

%

%

%

%

%

"

Since"2008"the"credit"risk"of"the"single"Euro"area"countries"started"to"be"effec6vely"priced."

We"classify"countries"as:"countries*under*sovereign*stress"(aka"PIIGS)"and"other*countries"

%

%

A%brief%narraKve%of%the%crisis%

Credit Default Swaps across Euro area countries(difference from the median)

Source: Thomson Financial DatastreamNote: The credit default swaps (CDS) are calculated for 10=year senior sovereign debt. The CDS for

=400

=200

0

200

400

600

800

1000

=400

=200

0

200

400

600

800

1000

Dec=05 Dec=06 Dec=07 Dec=08 Dec=09 Dec=10 Dec=11

Italy Ireland Spain Portugal Austria France

Germany Belgium Netherland Finland Greece

7400

countriesunder.sovereign.stress

7400

other.countries

7400

5"

A%brief%narraKve%of%the%crisis%

Long-term central bank liquidity(as percentage of bank assets)

Source: ECB, authors' calculations

Note: The chart plots the liquidity given by the ECB to banks of euro are countries at refinancing

0

2

4

6

8

10

12

14

0

2

4

6

8

10

12

14

DecF02 DecF05 DecF08

countriesHunderHsovereignHstress otherHcountries

Banks"in"the"stressed"countries"turned"more"to"the"liquidity"provided"by"the"Eurosystem,"especially"

longHterm.""Increasing"asymmetry,"demandHdriven,"in"the"implementa6on"of"monetary"policy"across"

countries."

Heterogeneity%of%bank%recourse%to%central%bank%liquidity%%

6"

A%brief%narraKve%of%the%crisis%The%example%of%Spain%(1):%%

Eurosystem%liquidity%to%Spanish%banks%

40%%of%SP%GDP%

7"

A%brief%narraKve%of%the%crisis%The%example%of%Spain%(2):%%

Total%divergence%between%public%Eurosystem%liquidity%&%all%the%other%internaKonal%funding%

H1200000"

H1000000"

H800000"

H600000"

H400000"

H200000"

0"

200000"

dicH92"

JunH93"

dicH93"

JunH94"

dicH94"

JunH95"

dicH95"

JunH96"

dicH96"

JunH97"

dicH97"

JunH98"

dicH98"

JunH99"

dicH99"

JunH00"

dicH00"

JunH01"

dicH01"

JunH02"

dicH02"

JunH03"

dicH03"

JunH04"

dicH04"

JunH05"

dicH05"

JunH06"

dicH06"

JunH07"

dicH07"

JunH08"

dicH08"

JunH09"

dicH09"

JunH10"

dicH10"

JunH11"

dicH11"

JunH12"

Millon

es%€%

Posición%de%Inversión%Internacional%Neta%de%España%Pos."Inv."Intern."Neta,"no"BdE" TARGET"

8"

Chart%1.%Foreign%claims%Sovereign%distress%countries%similar%to%Spain%and%Germany%looks%different%

9"

Chart%3.%%Short=term%interest%rates%on%small%and%large%loans%to%non=financial%corporaKons%

Source: ECB Source: ECB

Short&term&MIR&rates&on&loans&to&NFCs&&>&1&EUR&million Short&term&MIR&rates&on&loans&to&NFCs&&<&1&EUR&million

0.0

0.1

0.2

0.3

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

Jan-12

dispersion DE ESFR IT NLeuroBarea

0.0

0.1

0.2

0.3

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

Jan-12

dispersion DE ESFR IT NL

Heterogeneity%in%loan%rates%for%firms%

10"

Chart%4.%%Loan%supply%to%the%private%sector%

Source:(ECBNote:("EU0IMF(programme"(refers(to(Ireland,(Greece(and(Portugal(

Loans(to(non0financial(corporations((adjusted(for(securitisation)

010

05

0

5

10

15

20

25

30

35

010

05

0

5

10

15

20

25

30

35

2003

2003

2003

2004

2004

2004

2005

2005

2005

2006

2006

2006

2007

2007

2007

2008

2008

2008

2009

2009

2009

2010

2010

2010

2011

2011

2011

2012

ES IT DE FR EU/IMF(programme(countries euro(area

Heterogeneity%in%loan%volumes%for%firms%

11"

Increased%heterogeneity%in%credit%condiKons%and%standards%(for%all%the%pool%of%borrowers)%

"

"

"

"

"

"

"

"

"

"

"

Lending"standards"in"countries"under"stress"got"(and"s6ll"get)"6ghter"in"each"quarter"than"in"

the"other"countries"

A%brief%narraKve%of%the%crisis%

Lending standards for business loans in Euro area countries(net%percentage%of%banks%tightening%standards)

Source: ECB, National Central Banks, authors' calculation

>40

>20

0

20

40

60

80

100

>40

>20

0

20

40

60

80

100

37621 38717 39813

other%countries countries%under%sovereign%stress euro%area

12"

•  Standard"VAR"model"es6mated"recursively"on"a"panel"of"12"euro"area"countries"

separated"in"PIIGS"and"nonHPIIGS"with"data"on"credit"condi6ons"and"standards,"

monetary"policy,"macro"and"other"financial"data"

•  Responses"by"country"of"the"Bank"Lending"Survey"(BLS):"1.  BLS"reports"loan"condi6ons"for"all"the"applicants"(including"rejected"borrowers)"2.  Possible"to"disentangle"subHcredit"channels:"changes"in"credit"condi6ons"due"to"

•  bank"balance"sheet"strength"(bankHlending"channel)"

•  net"worth,"risk"and"collateral"of"firms"and"households"(balance"sheet"channel)"

3.  We"analyse"for"PIIGS"and"nonHPIIGS:"

•  Impact"of"monetary"policy"(MP)"on"GDP"(or"prices)""

•  Impact"of"MP"on"GDP"through"changes"in"loan"condi6ons"due"to"bank"or"

borrower"balance"sheet"strength"(mapped"into"BLS"observables)"

•  MP"both"through"EONIA"rates"and"longHterm"public"(Eurosystem)"liquidity;"

iden6fica6on"with"Cholesky"or"sign"restric6ons"

Method%and%data%VAR%model%with%loan%data%

13"

Effec6veness"of"monetary"policy"on"GDP"growth"

Recursive"impulse"responses"of"GDP"growth"to"a"monetary"policy"shock"

05

1015

2007Q3

2008Q4

2009Q4

2010Q4

2011Q4

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

Countries under stress

05

1015

2007Q3

2008Q4

2009Q4

2010Q4

2011Q4

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

Other countries

-0.4

-0.2

0

0.2

The"impact"of"a"monetary"policy"shock"is"stronger"during"the"crisis"and"has"stronger"effects"

in"countries"under"stress,"which"is"good"

Monetary%policy%in%heterogeneous%framework%

14"

Ra6onalising"the"result"with"the"theory"of"the"credit"channel"of"monetary"policy""

"  Monetary"policy"has"an"impact"on"economic"condi6ons"if"there"are"significant"fric6ons"in"

borrowing"due"to"balance"sheet"constraints"(Bernanke"and"Gertler,"1995)"

"  In"countries"where"financial"fric6ons"in"borrowing"increase"significantly,"the"external"finance"premium"also"increases,"poten6ally"making"the"credit"channel"“more"ac6ve”"and"

the"effect"s"on"GDP"and"prices"stronger"

"

To"check"the"impact"of"different"channels"of"transmission"we"design"

counterfactuals"experiments"(Bernanke,"Gertler,"and"Watson,1998;"Sims"and"Zha,"2006)"

"  Construct"hypothe6cal"responses"that"features"only"“direct”"impact"of"an"interest"

rate"movement"on"GDP"and"neutralise"the"indirect"effects"through"the"BLS"credit"

variables"

"  Check"the"difference"between"the"impact"in"the"full"system"and"the"impact"without"

the"various"credit"channels""

"  The"difference"between"the"two"impacts"quan6fies"the"amplifica6on"effects"of"the"

credit"channel"

"

The%amplificaKon%mechanism%of%the%credit%channel%%

15"

The%amplificaKon%mechanism%of%the%credit%channel%%

2007Q3

2008Q4

2009Q4

2010Q3

2011Q3

Panel A. Countries under sovereign stress

Bank-lending channel Credit demand channelNon-financial borrower's balance sheet channel

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

total effect effect without the channel

16"

1.  The"transmission"mechanism"of"the"single"monetary"policy"has"changed"over"

2007H2011"and"the"impact"is"stronger"during"the"crisis,"especially"for"PIIGS"

2.  A"significant"amplifica6on"through"the"credit"channel"in"PIIGS:"the"bankH

lending"channel"is"strong"in"2008H09;"the"nonHfinancial"borrowers"balance"

sheet"channel"is"strong"throughout"the"en6re"period"

3.  Current"policy"framework"is"s6ll"insufficient"to"reduce"credit"availability"

problems"stemming"from"deteriorated"firm"net"worth"and"risk"condi6ons,"

especially"for"small"firms"in"distressed"countries"

4.  The"bankHlending"channel"is"par6ally"mi6gated"by"the"ECB"non"standard"

measures?""The"laIer"replaces"the"interbank"market"providing"beIer"liquidity"

condi6ons"for"banks,"in"turn"sobening"lending"condi6ons"for"borrowers?"

Pre=view%of%the%results% Results%

17"

SubsKtuKon%between%private%and%public%provision%of%liquidity%

Effects of interbank transactions on long-term central bank liquidity (LTRO)Recursive)panel)estimates

00.2

00.1

0

0.1

0.2

0.3

0.4

Dec007 Aug008 Apr009 Dec009 Aug010 Apr011countries)under)sovereign)stress other)countries

Fixed)0rate)fullallotment)

Banks"in"countries"with"sovereign"debt"problems,"which"get"less"funding"from"the"private"

interbank"market,"increase"the"long"term"borrowing"from"the"Eurosystem"in"the"next"period."

18"

"

Impact%of%LTROs%on%bank%behaviour%

2)#Change#in#credit#demand

Effects of long-term central bank liquidity (LTROs) on lending conditions and credit demandRecursive)panel)estimates

1)#Changes#in#lending#standards#and#conditions#

00.5

00.4

00.3

00.2

00.1

0

0.1

0.2

0.3

Dec007 Aug008 Apr009 Dec009 Aug010 Apr011

countries)under)sovereign)stress other)countries

Fixed)0rate)fullallotment)starts

00.2

00.15

00.1

00.05

0

0.05

0.1

0.15

0.2

Dec007 Aug008 Apr009 Dec009 Aug010 Apr011

countries)under)sovereign)stress other)countries

Fixed)0rate)fullallotment)

In"turn,"the"recourse"to"LTRO"soben"credit"standards"and"condi6ons"in"the"next"period"

19"

Main%points%Large"heterogeneity"in"borrowing"condi6ons"and"in"the"Euro"area"monetary"

transmission"channel"between"distressed"(PIIGS)"and"other"EA"countries"

"

•  Bank"lending"channel"was"not"key"in"2010H11"(and"2008H09)""

•  But,"given"2012,"without"banking"union"it"is"impossible"to"survive"(notably"

deposit"insurance,"a"Euro"area"TARP"and"banking"supervision)"

–  PIIGS"survive"because"of"the"Eurosystem"liquidity,"but"PIIGS"exposure"is"massively"

increasing"and"runs"on"PIIGS"are"happening"

–  Poli6cal"problems"(moral"hazard"of"TARGET"debtor"and"creditor"countries),"

bargaining"threats,"and"increasing"credit"risk"for"TARGET"creditor"countries"

–  Other:"what"about"current"losses,"retail"runs"vs."wholesale"crossHborder"contagion…"•  The"firm"balance"sheet"channel"is"s6ll"very"important"for"PIIGS"in"2010H11"(also"

in"2008H09)"and"ECB"policies"very"limited"power"to"reduce"credit"fric6ons""

–  ECB"could"buy"sovereign"and"firm"stuff,"but"poli6cal"limita6ons"

–  UK"and"Japanese"alterna6ve"ways"to"increase"credit"supply"for"firms"

–  Debt"overhang"and"deleverage:""e.g."Spain"versus"US"and"Sweden"aber"their"crisis"(high"infla6on,"bankruptcy"code"for"banks,"loans"with"full"recourse,"defaults…)"

20"

4

the United States could see several more percentage points of household deleveraging in the months and years ahead as the foreclosure process continues.

Historical precedent suggests that US households could be as much as halfway through the deleveraging process. If we define household deleveraging to sustainable levels as a return to the pre-bubble trend for the ratio of household debt to disposable income, then at the current pace of debt reduction, US households would complete their deleveraging by mid-2013. When we compare US household progress to the Swedish deleveraging episode, in which the ratio of household debt to income declined by more than 40 percentage points, we see that US household deleveraging is a little more than one-third complete. Because US interest rates today are lower than interest rates were in Sweden during its deleveraging, US households may be able to sustain somewhat higher levels of debt (Exhibit E3).

Even when US consumers finish deleveraging, however, they probably won’t be as powerful an engine of global growth as they were before the crisis. One reason is that they will no longer have easy access to the equity in their homes to use for consumption. From 2003 to 2007, US households took out $2.2 trillion in home equity loans and cash-out refinancing, about one-fifth of which went to fund consumption. Without the extra purchasing that this home equity extraction enabled, we calculate that consumer spending would have grown about 2 percent annually during the boom, rather than the roughly 3 percent recorded. This “steady state” consumption growth of 2 percent a year is similar to the annualized rate in the third quarter of 2011.

US government debt has continued to grow because of the costs of the crisis and the recession. Furthermore, because the United States entered the financial crisis with large deficits, public debt has reached its highest level—80 percent of GDP in the second quarter of 2011—since World War II. The next phase of

Exhibit'E3

SOURCE: Haver Analytics; Statistics Sweden; McKinsey Global Institute

Credit boom Deleveraging

NOTE: 2011 figures are as of Q2 2011.

Spain

(Year 0 = 2007)

United States

(Year 0 = 2008)

United Kingdom

(Year 0 = 2008)

Sweden

(Year 0 = 1988)

Household debt% of disposable income

-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9

90

80

160

150

140

130

120

110

100

-41 p.p.

-10 p.p.

-6 p.p.-15 p.p.

70

0

US households are about one-third of the way to the Swedish level of debt reduction

Peak household

debt

Years

Too%slow%deleveraging%in%Spain,%but%a%big%private%(&%public)%debt%

This"is"household"leverage"but"the"big"credit"“bubble”"in"Spain"was"on"banks’"and"firms’"debt"

21"

1. Connection between sovereign defaults and the euro

� The Stability and growth pact said de�cits below 3%, debts below 60% and �no bailout�clause!� The key issue was governance, endow the ECB with credibility. There was little discussion of othermotives such as:

�Externalities (tax competition, TOT e¤ects)

�Have room to �nance regional bad shocks when exchage rates are not avialable (paternalistic? ex-ternality too?)

� When Greece reveals serious debt problems at the end of 2009, the reaction is that avoiding default iskey for the survival of the euro.

� The same view is kept as Ireland, Portugal, Spain and Italy start showing weak �scal numbers andgrowing debt.

� Soft rescue packages �nanced in large part by the EU and ECB (also the IMF) are given to Greece,Ireland and Portugal. Spain is coming next. Italy might follow.

� Why this generosity? Why defaults are connected to the euro?

�The germans originated this mess for internal reasons :)

�A¤ected countries will leave the euro and try to solve their �scal problems with in�ation and this iseven more costly

�Taxpayer is local vs. creditors are foreign? Why do markets not price this?

��Too big to fail�in another arena (not well articulated?)

� Rescue packages from EU/ECB/IMF:

�Greece: 110 b. May 2010 and 130b. October 2011 (GDP 215b. pop. 11.3)

�Ireland: 85b. November 2010 (GDP 156b. pop 4.4m. )

�Portugal: 78b. May 2011 (GDP 171b. pop 10.6m.)

�Spain: ?? October 2012 (GDP 1057b. pop 46m.)

� Details:

�Much longer than usual IMF packages, which usually last only 3 years. These packages have beenfrom 7 to even 30 years in the case of Greece.

�Slow �scal adjustment due to the feeling that this would keep growth

�Initially they held a penalty rate (300 basis points) but the EU and ECB eliminated this in laterperiods

�Packages used for both re-capitalize banking systems and cover budget de�cits

�Only if debt path is deemed sustainable. Otherwise, restructuring is required (�private sector involve-ment�). This happened in the second Greek bailout, with a haircut of about 50%.

� Euro-wide initiatives:

�ECB liquidity for banks and other �nancial institutions 200b.

�European Financial Stability Fund 750b.

2. Flaws in the design of the euro

� Keynes and Mundell took over and displaced all other considerations:

�Liquidity management in normal times: dealing with nominal rigidities�Liquidity management in crisis periods: dealing with systemic risk

� The need for a banking union

�Otherwise we have the current mess in which a �nancial crisis leads to a sovereign crisis�Magni�ed by liquid secondary markets:� Self-ful�lling crises of a new type� Excessive borrowing when institutions are unclear

� Do we need a �scal union?

�Countercyclical transfers, that is, Mundell is back!�But the problem is not asymmetric shocks, but regional banking regulation/supervision.

3. Where are we now? What should we do?

� We need to reform the euro, but implementing the banking union now is tricky:

�(Banking) We are all in favor of insurance. But this is like purchasing insurance as the house isburning

�(Fiscal) Fiscal union for European expenses. Beyond this, we need to articulate a �too big to fail�argument for sovereigns. It will not be politically correct.