Transcript What is Wrong with the Euro-Zone and What to do about it?

Andrew Baker
What is wrong with the Euro Zone
and what to do about it?
 Break up messy and potentially catastrophic – need a
better designed Euro zone.
 1. The Macroeconomic design of the Euro zone
 2. The history and politics of monetary union
 3. The financial crash of 2008 and the response
 4. How to re-design the macroeconomic framework
The macroeconomic design of the
Euro-zone
 Design is dysfunctional and even pathological
 What is a monetary union – what does it mean for
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macroeconomic policy?
States give up two macroeconomic policy instruments and
retain one
The centralisation of interest rate policy
Individual Euro-zone countries have different interest rate
requirements at different parts of the cycle
Governments have lost a crucial macroeconomic policy
instrument for steering economic activity in their
jurisdiction
The macroeconomic design of the
Euro-zone
 Euro zone states have also lost the exchange rate as a
policy lever
 Only one macroeconomic policy lever remains at the
national level – fiscal policy – making it extra
important in a monetary union
 24 January 2001 under article 99 (4) of TEC, the
Commission asks ECOFIN to address a critical
recommendation to Ireland for following procyclical
budgetary policy
 In a monetary union fiscal policy needs to perform a
countercyclical role.
The macroeconomic design of the
Euro-zone
 Unfortunately fiscal policy frameworks in the Euro-
zone overlook this basic insight
 The SGP made a deficit-GDP ratio of 3% the centre
piece – a questionable policy target in a monetary
union?
 The fiscal compact negotiated in 2012 – a tougher
bolstered version of the SGP – but based on the same
macroeconomic thinking and principles
 A deficit-GDP ratio is inherently procyclical and can
further amplify the procyclicality caused by interest
rate and exchange rate centralisation
The history and politics of
monetary union
 European Monetary Union was a political project driven by
particular political dynamics
 It took place against the backdrop of German Unification
in 1990
 The political deal that drove monetary union – unreserved
French support for German unification in return for
Germany giving up the Deutschemark and surrendering de
facto German control of European monetary policy, with
France having a seat at the table of a new European
monetary institution
 The quid pro quo was that Germany got to design the
institutional and governance structures of the new
Monetary Union.
The history and politics of
monetary union
 The German model: independent anti inflationary
central bank; export growth model based on high end
luxury goods; social partnership and co-operation.
 A whole system of supportive social and institutional
relationships made Germany a successful export
economy
 The supportive social and institutional context that
made German macroeconomic frameworks work were
not evident elsewhere in Europe
The history and politics of
monetary union
 ECB price stability mandate – inflation below 2% - a
German design – little else – no lender of last resort
function, crisis management not specified
 The German fear of fiscal free riding, rogue
governments buying into its credibility informed the
SGP
 The fear of rogue profligate governments has
persisted to this day and has informed the design of
the fiscal compact
The Financial Crash of 2008
 The sovereign debt crisis is not really a sovereign debt crisis
 Total Irish public debt was 12% of GDP in 2007, but shot up
to 110% of GDP – 3 main Irish banks asset footprint over
400% of GDP – once liabilities were guaranteed private
sector debt was transferred onto public balance sheets
 The combustion of unsustainable banking models has cost
globally $4-11 trillion – only world wars come with a hefitier
price tag
 The profligate governments discourse is wrong. Europe’s
sovereign debt crisis is a transmuted, elongated and
camouflaged banking crisis
The Financial Crash of 2008
 Core European country banks bought lots of peripheral
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European debt (sovereign and private) over several years in their
search for yield
Leverage of 40:1 in many cases – European banks are Too Big to
Bail
French government bonds have come under pressure not
because France cannot afford to pay for its welfare state, but
because France’s bloated debt ridden banks are too big a liability
for the state.
‘Austerity Europe’ – required so that the state and its balance
sheet can act as the shock absorber for the entire system
Banks – ‘Bank on the State.’ (Haldane)
Greece – the outlier
Re-designing the Euro-Zone’s
macroeconomic governance?
 Europe’s banking problem caused and is compounding the
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sovereign debt problem
How to create institutions that minimize future crises and
refrain from politically unsustainable forms of austerity when
crises do hit is precisely the problem?
The inherent procyclicality of macroeconomic policy is one of
the problems that needs to be overcome
A counter cyclical fiscal constitution is needed, - automatic
adjusters according to measures of GDP growth
Not a soft solution – rules to require surpluses to be built up
during growth years, but providing more flexibility in lean years.
The ECJ to have an adjudication role.
A limited fiscal federation and a limited common bond
mechanism?
Re-designing the Euro-Zone’s
macroeconomic governance?
 The ECB tighter control of financial innovation, lean
against asset bubbles and require national central
banks to operate macroprudential regulation (host
country)
 Sold to Germany – as limiting the need for future bail
outs
 Hard but flexible countercyclicality is needed
 Imposed German universalism is not working and will
not work