Transcript Economic stability loss

Creating the Monetary Union
led to the current crisis, but
breaking up the Euro would be
difficult and costly
by
Assaf Razin
December, 2011
The creation of the euro should now be
recognized as an experiment that has led to
the sovereign debt crisis in several countries,
the fragile condition of major European banks,
the high levels of unemployment, and the
large trade deficits that now exist in most
Eurozone countries.
Although the European Central
Bank managed the euro in a way that
achieved a low rate of inflation, other
countries both in Europe and elsewhere have
also had a decade of low inflation without
incurring the costs of a monetary union.
What led to Monetary Union
The initial impetus that led to the European
Monetary Union and the euro was actually
political rather than economic. Political
leaders generally favored the creation of
the euro as a step toward deeper
political integration.
The shift of responsibility for monetary
policy from national capitals to a single
European Central Bank in Frankfurt would
signal a shift of political power.
History
The Treaty of Rome launched the Common
Market in 1957.
The Common Market developed into the
European Economic Community in 1967
and the European Union in the Maastricht
treaty of 1992, creating not only a larger
free trade area but also providing for the
mobility of labor and other aspects of an
integrated European market for goods and
services.
Monetary Union
The political process evolved through the
Maastricht Treaty’s creation of the
European Monetary Union and the plans
for the single currency which eventually
began in 1999
A single currency means:
1. that all of the countries in the monetary
union have the same monetary policy and
the same basic interest rate, with interest
rates differing among borrowers only
because of perceived differences in credit
risk.
2. A fixed exchange rate within the
monetary union and the same exchange
rate relative to all other currencies, even
when individual countries in the monetary
union would benefit from changes in
The Euro Deal
As the euro became a done deal,
countries that had previously had to pay a
large interest premium found themselves
able to borrow on the same terms as
Germany; this translated into a big fall in
their cost of capital. The result was
bubbles, inflation, and in the aftermath of
the bubbles and inflation.
When a county has its own monetary
policy, it can respond to a decline in
demand by lowering interest rates to
stimulate economic activity.
But the European Central Bank must make
monetary policy based on the overall
condition of all the countries in the
monetary union.
This means interest rates that are too high
for those countries with rising
unemployment and too low in other
countries where wages
are rising too rapidly.
The shift to a monetary union and the tough
anti‐inflationary policy of the European Central
Bank caused interest rates to fall in countries
like Spain and Italy where expectations of high
inflation had previously kept
interest rates high.
Households and governments in those
countries responded to the low interest rates
by increasing their borrowing, with
households using the increased debt to
finance a surge in home building
and house prices while governments borrowed
to finance budget deficits that accompanied
larger social transfer programs.
The result was rapidly rising ratios of public
and private debt to GDP in
several countries, including Italy, Greece,
Spain and Ireland. Despite the
increased risk to lenders that this implied,
the global capital markets did
not respond by raising interest rates on
countries with rapidly rising
debt levels.
A different market dynamic affected the
relation between the commercial banks and
the European governments. Since the
banks were heavily invested in government
bonds, the declining value of those
bonds hurt the banks.
Sovereign Debt and Monetary
Union
• When entering a monetary union, member
countries change the nature of their
sovereign debt in a fundamental way.
They cease to have control over the
currency in which their debt is issued.
During the euro-bubble years
there were huge capital flows to
peripheral economies, leading
to a sharp rise in their costs
relative to Germany
Capital inflows to Spain
Now that the bubble bursts,
should the adjustment be rising
wages in Germany or falling
wages in Spain? The ECB
signals that no inflation in
Germany will be tolerated. The
recipe is for a prolonged slump
in the periphery.
Fiscal Federalism
• The transfer of economic resources from
members with healthy economies to
members who suffer economic setback
can best be done through fiscal
federalism—most of the risk is privately
uninsurable.
• This is a key difference between US and
Eurozone. It remains to be seen whether
the EU will develop more elaborate
institutions for carrying out fiscal transfers
Iceland vs. Ireland
Iceland’s positive swing has been about
twice as large as Ireland’s — and we’re
talking an extra 10 points of GDP here.
That’s a lot of extra stimulus, and to the
extent that it was due to devaluation, that’s
a major plus for having your own currency
UK Government Bonds vs. Spain
Government Bonds
• Financial markets can force monetary
union countries’ sovereigns into default.
• The financial markets attach a much
higher default risk on Spanish than on UK
government bonds. In early 2011 this
difference amounted to 200 basis points.
UK Government Bonds
Suppose that investors fear that the UK
government might be defaulting on its debt.
They will sell their UK bonds, driving up the
interest rate. After selling these bonds these
investors would have pounds that they would
want to get rid of by selling them in the foreign
exchange market. The price of the pound would
drop until somebody else would be willing to buy
these bonds. UK money stock will remain
unchanged.
Investors cannot precipitate
liquidity crisis for a non sigle
currency area country
• Even if the UK government cannot find the
funds to roll over its debt it would force the
Bank of England to buy up the government
securities.
• Thus, investors cannot precipitate a
liquidity crisis in the UK that could force
the UK government into default.
Debt Dynamics: member of a
single currency area and non
member
• UK—currency depreciation follows
sovereign debt crisis and inflation
increases. Real value of debt falls.
• Spain—To regain competitiveness wages
are cut following sovereign debt crisis.
Deflation raises the real value of the debt.
“Internal” depreciation vs. “Real”
Depreciation
• The only way is to reduce costs, relative to
countries inside and outside the currency
area. Economists sometimes refer to this
as a “real depreciation” or “internal
devaluation”. That requires slower price
and wage growth or faster productivity
growth than elsewhere. Given today’s low
inflation rates, it means outright declines in
prices and wages.
Inflation in the “north” deflation
in the “south”
• Real exchange rate changes within a
currency area come about with inflation in
the “north” deflation in the “south”. But if
the “north” pursue strict anti-inflation
policy, deflation in the south is enhanced.
Competitiveness within the Eurozone: decade and a half before the
crisis
• Greece, Ireland, Portugal and Spain lost
a lot of competitiveness:
• Low interest rates led to a surge in
domestic demand. And sharp rises in real
wages.
• Productivity growth was not vigorous
enough to compensate.
Debt crisis and fixed
exchange rate:
lessons from Latin America
Argentina is a case in point. In 2001, it ran
through a series of governments before
triggering the world’s then-biggest default
($100bn; so small compared to Italy’s
€1.9tn bond market).
To restore competitiveness without breaking
Argentina’s euro-like currency peg, he
engineered a “synthetic devaluation”. Acrossthe-board export subsidies and import duties
came straight out of the textbooks, but didn’t
work. Just as they often do in Europe today,
investors saw the country’s debt dynamics still
working against it.
Restoring competitiveness
against bad debt dynamics
To restore competitiveness without
breaking Argentina’s euro-like currency
peg, he engineered a “tax-based
devaluation”. Across-the-board export
subsidies and import duties came straight
out of the textbooks, but didn’t work. Just
as they often do in Europe today, investors
saw the country’s debt dynamics still
working against it.
Bad debt dynamics
Default fears led to higher bond yields,
which led to lower growth and smaller
government revenues. This made default
more likely in a process that soon became
self-fulfilling. After three years of
recession, much of southern Europe may
already on the brinks of default.
Debt Deflation
• The more wages and prices fall, the bigger
debt burdens become in real terms. If the
economy continues to there will be less
money to service debts. But the more they
lower wages and prices, the harder is the
debt overhang burden is to bear.
• Irving Fisher (80 years ago) notes that the
struggle to reduce debts can sometimes
increase indebtedness.
Expected length of current crisis
• Long time before we can the crisisEuropean countries are expected to
recover!
• Problems are not going to go away soon
for the European Monetary Union and the
EU
Trends in Euro zone
• Prolonged recession
• Beyond Greece there will be more debt
restructurings
• Banks will be nationalized
• ECB buys debt—price stability plays back
role to financial stability
Three difficult-to-solve Problems
• 1. Absence of adequate adjustment
mechanism to correct current account
imbalances among member states.
Internal devaluation lead to currency
mismatch on a member’s balance sheet.
The result: Heavily indebted,
uncompetitive, countries.
• 2. Absence of bank regulation at the level
of the union leads to race-t-the-bottom
regulation competition among members.
3. Inadequate supply of liquidity
because national governments
in the “south” have limited
capacity to issue and redeem
safe assets that can be bought
and sold at predictable prices.
The ECB is reluctant to be a
lender of last resort to national
governments.
Sovereign Debt And Banks
By the fall of 2011, several European
countries had debt to GDP ratios
that made default a serious possibility.
Sharp write‐downs in the value of their
sovereign debt would do substantial
damage to the European banks and
possibly to banks and other financial
institutions in the United States.
Strategies to deal with
this situation
1. The Eurozone leaders agreed in
October 2011 that the banks should
increase their capital ratios and that the
European Financial Stability Facility
(EFSF) should be expanded from 400
billion euros to more than a trillion Euros to
provide insurance guarantees that would
allow Italy and potentially Spain to access
the capital markets at reasonable interest
rates.
• 2. All 17 members of the Eurozone, plus 6
other countries who wish to join the Euro
one day, signed in December 2011, an
intergovernmental pact that would
enforce stricter fiscal discipline. Sanctions
will be imposed on countries that fail to
stay with limits of budget deficits, inserting
balance budget legislations of members,
with the European Court in charge.
This plan to increase the banks’ capital
won’t work because the banks
don’t want to dilute current shareholders by
seeking either private or public capital.
Instead, they are reducing their lending,
particularly to borrowers in other countries,
causing a further slowdown in European
economic activity.
2. The second strategy calls for the
European Central Bank to buy the
bonds of Italy, Spain and other high debt to
keep their interest rates low.
The ECB has already been doing that to a
limited extent but not enough
to stop Greek and Italian rates from
reaching unsustainable levels.
3. The third strategy is favored by those
who want to use this crisis to
advance the development of a political
union. They call initially for a
“transfer union” or a fiscal union in which
those countries with budget
surpluses would transfer funds each year
to the countries running
budget deficits and trade deficits.
Greece
The Greek budget deficit of 9 percent of
GDP is too large to avoid a further outright
default on its national debt. With a current
debt to GDP ratio of 150 percent and the
current value of Greece’s GDP falling in
nominal euro terms at 4 percent, the debt
ratio would rise in the next 12 months to
170 percent of GDP. Rolling over the debt
as it comes due and paying higher interest
rates on such debt would raise the total
debt even more quickly.
Cutting the interest bill in half by a 50
percent default while balancing the rest of
the budget would only reduce the deficit
very slowly, from 150 percent now to 145
percent after a year, even if no payments
to bank depositors and other creditors
were required. It is not clear that financial
markets will wait while Greece walks along
this fiscal tightrope to a sustainable debt
ratio well below 100 percent.
Italy is much better
Italy already has a primary budget surplus
with tax revenue exceeding non‐interest
government outlays by about one percent
of GDP and a slightly positive rate of
growth. With interest on the national debt
now equal to about 5 percent of GDP,
Italy’s total budget deficit is about four
percent of GDP. A two percent of
GDP reduction of that deficit would be
enough to start a decline in the ratio of
debt to GDP.
But this is not going to solve the
competitiveness problem
Reducing the problem of large budget
deficits and the related problem of the
commercial banks that have invested in
government bonds would still not solve the
long‐term competitiveness problem
caused by monetary union.
Leaving the Euro?
The alternative is for Greece to leave the
Eurozone and return to its own currency.
Although there is no provision in the
Maastricht treaty for a country to leave,
political leaders in Greece and other
countries are no doubt considering that
possibility for Greece. While Greece is
currently receiving transfers from the other
Eurozone countries, it is paying a very
high price in terms of unemployment and
Bank crises in Greece?
The primary practical problem of leaving
the euro is that some Greek businesses
and individuals have borrowed in Euros
from banks outside Greece. Since those
loans are not covered by Greek law, the
Greek government cannot change the
obligation from Euros to New Drachmas.
• The decline in the New Drachma relative
to the euro would make it much more
expensive for the Greek debtors to repay
Strings attached
But Germany is now prepared to subsidize
Greece and other countries to sustain the
euro, Greece and others might
nevertheless decide to leave if the
conditions imposed by Germany are
deemed to be too painful to accept.
But breaking up the Monetary
Union would be difficult and
costly.
Ireland Boom
Philip Lane of Trinity College notes: “There
was a genuine Irish economic miracle,
with very rapid output, employment and
productivity growth during the 1994-2000
period.” Without entry into the eurozone,
this might have petered out. But the fall in
interest rates increased the risk that a
credit-fuelled property bubble would
emerge. So, indeed, it did.
Ireland Bust
The ratio of private credit to GDP jumped from
around 100 per cent in 2000 to 230 per cent in
2008. Foreign lenders played a huge role in
funding this boom: the net foreign liabilities of
domestic banks went from 20 per cent of GDP in
2003 to over 70 per cent in early 2008.
The global financial crisis caused an
immediate cessation in the capital inflows.
In panic-stricken response, the Irish
government guaranteed bank debt in
September 2008. As the fiscal costs
mounted, driven by the slump and the
need to rescue the banks, what began as a
financial crisis ended up as a crisis in
public debt.
The direct costs of recapitalizing the system
are set to be around 36 per cent of GDP.For
comparison, the cost of the Asian financial
crisis to South Korea was 31 per cent of GDP,
while the cost of today’s crisis to Iceland
might be only 13 per cent of GDP. On the last,
according to the IMF, general government
debt could be 123 per cent of GDP by 2014. A
little over a third of this increase in the public
debt ratio would then be a direct result of
recapitalizing the banks
Ireland’s Banks run
• Ireland borrowed massively to stop its
run—70 percent of GDP, including $90
billion from the European Union Loan,
leaving the country with more debt-to-GDP
than Greece.
• By saving the banks, and their creditors,
the government “bankrupted” the country.
• Unemployment is 14 percent and output is
down by 10 percent.
Ireland Debt Overhang
• The overhang of toxic debt accumulated after a decade
in which Irish banks borrowed in the international
wholesale markets to finance a property development
bubble.
• Following the burst of the bubble the government
committed 50 billion Euros-one third of GDP-to fill the
hole.
• Back in 2008 the government gave 100 percent
guarantee to all bank deposit and to most of their debt.
• By September and October 2010 ECB lent to Irish banks
one quarter of all ECB lending to Eurozone banks.
Ireland financial
sector debt
crisis
Ireland’s volatile FDI inflows
Spain
• These big capital inflows raised demand
for Spanish goods and services, leading to
substantially higher inflation in Spain than
in Germany and other surplus countries.
• Both countries are on the euro, so the
divergence reflects a rise in Spain’s
relative prices.
Spain: The aftermath of the
housing bubble
When the bubble burst, it left Spain with much
reduced domestic demand, and highly
uncompetitive within the euro area thanks to the
rise in its prices and labor costs.
If Spain had had its own currency, that currency
might have appreciated during the real estate
boom, then depreciated when the boom was
over.
Since Spain does not have its own currency it
seems doomed to suffer years of grinding
deflation and high unemployment.
Relative Price of Non-Tradables
Where are Spain’s budget deficits
in all this?
Spain’s budget situation looked very good
during the boom years.
It is running huge deficits as a consequence,
not a cause, of the crisis:
Tax revenue has plunged, and the
government has spent some money trying
to alleviate unemployment.
The Crash of 2008 and the rescue
of the banks
• In the absence of the “lender of last resort” for
the ECB, there is a risk to the Euro when each
member state attempts to rescue the banks
independently.
• In the aftermath of the financial crisis Spain,
Greece, Italy, and Ireland created huge budget
deficits
The European authorities must coordinate a
rescue package across different member states
to facilitate fiscal consolidation of high deficit
countries.
But how sharp could be the budget cuts?
Greece: A Vicious circle
• Greek high budget deficits raise the risk
premium on Greek government bonds.
• High risk premium puts Euro arrangements at
risk.
• Euro authorities for budget cuts.
• Budget cuts depress economic activity and
reduce tax revenues.
• The further increase in the deficit raises the risk
premium on Greek government bonds.
• Etc., Etc., …
Sovereign debt spread
Sovereign debt spread
Germany vs. France
Spillover between euro-zone
member states
• When investors dump government bonds,
they also raise interest rate in theses
bonds and force the government to reduce
its budget deficit. This is likely to reduce
downturn; hence increase in deficits. Thus
by selling country 1 bonds they also
increase riskiness of government 2 bonds.
Investors trying to avoid risk
create more risk elsewhere
• The essence of the problem is that
investors who sell government bonds of
one country do not take into account the
spillover effects on other country bonds.
The problem of contagion is high in eurozone because of the intensive trade
between its members.
• By forcing early exit strategy in one
member state they also force other
member states to do so.
Current Account Imbalances
External vs. Internal
Devaluation
The euro allowed these internal
imbalances to grow unchecked and
now stands in the way of a speedy
adjustment, because euro-area
countries whose wages are out of
whack with their peers’ cannot
devalue.
Integration of Public Finance in the
European Union
• Makeshift assistance to Greece leaves
Spain, Italy, Portugal and Ireland budget
problems resolved.
• Coordinated fiscal consolidation by Euro
finance ministries; and the creation of a
well organized Euro bond market for
executing bailouts, seem to be high on the
agenda.
• The European Commission proposes the
establishment of European Monetary Fund.
Political and Fiscal Union requires
Fiscal Coordination
• The architects of the euro at least
predicted such problems, even if they
could not solve them. The “stability and
growth pact” was supposed to limit each
country’s budget deficit to 3% of gdp and
public debt to 60% of GDP. It failed, in part
because France and Germany refused to
abide by it—and even rewrote the rules
when they breached the deficit limit.
A Euro breakup?
• No country can be forced off the Euro
against its will
• No country would voluntarily abandon it—
the shock of leaving would outweighs any
advantage of life outside
Sources of Fiscal Problems
• Pro-cyclical behavior by fiscal authorities
before the recent financial crisis
• Direct fiscal costs of the financial crisis
• Government revenue sources weakened
by the financial crisis
• End of asset booms
Conclusion
The UK economist Charles Goodhart once described
banks as international in life, but national in death. In the
case of a single currency union you should make them
European in death.
•
Wholesale banking is genuinely cross-border. German
and UK banks have crippling exposures to Ireland,
French and German banks to Greece, Spanish banks to
Portugal. If one peripheral country defaulted, we would
see a contagious banking crisis that would overwhelm
some governments’ ability to cope
The Crisis
Incautious lenders lent borrowers the rope
with which the latter could hang
themselves, be they irresponsible
governments (as in Greece) or foolish
private entities (as in Ireland and Spain).
The result was huge indebtedness.
Indebtedness in the Eurozone
Common Euro Bond
At that point the focus will shift to Italy. Italy
accounts for 18 per cent of the guarantees.
I suspect Italy will not be willing to honour
its bail-out commitment if and when Spain
were to enter the mechanism. Even if Italy
were willing, it might not be able to do it,
given its own debt sustainability problems.
And once Italy defaults on its commitment,
I cannot see Germany and France willing
to bankroll the entire system unilaterally. At
that point, the intra-governmental approach
will break down and the eurozone will
make the big jump – towards a common
European bond.
But a common Eurobond generates moral
hazard—gives an incentive to excessive
spending.
Benefits of Currency Union
As we know from the theory of optimum
currency area, there are benefits and
costs to currency integration.
Benefits are reduced costs of doing
business. If they are large, forming
currency areas lead to large increases in
trade. Intra Eurozone trade has increased
but not significantly since the
establishment of the EMU.
Costs of Currency Union
The key problem is building concensus on
how best to stabilize prices and
employment after asymmetric shocks.
Labor mobility (Mundell), Fiscal integration
(Kenen), A Strong central bank serving as
lender of last recourse, and a fiscal unit to
bailout sovereign debts, lubricate
equilibration, but do not automatically
resolve member conflicting interests.
Costs
– Economic stability loss
• LL schedule
It shows the relationship of the country’s economic
stability loss from joining. It slopes downward.
Reason: The economic stability loss that arises
because a country that joins an exchange rate
area gives up its ability to use the exchange rate
and monetary policy for the purpose of stabilizing
output and employment.
It is lower, the higher the degree of economic
integration between a country and the fixed
exchange rate area that it joins.
The LL Schedule
– Economic stability loss
• The economic stability loss that arises because a
country that joins an exchange rate area gives up
its ability to use the exchange rate and monetary
policy for the purpose of stabilizing output and
employment.
• It is lower, the higher the degree of economic
integration between a country and the fixed
exchange rate area that it joins
LL schedule
•
•
Economic stability
loss for the joining country
Degree of economic integration between the
joining country and the exchange rate area
The GG-schedule
– Monetary efficiency gain
• The joiner’s saving from avoiding the uncertainty,
confusion, and calculation and transaction costs
that arise when exchange rates float.
• It is higher, the higher the degree of economic
integration between the joining country and the
fixed exchange rate area.
GG schedule
Monetary efficiency
gain for the joining country
Degree of economic integration between the joining
country and the exchange rate area
Threshold for Optimum
Currency Area
Gains and losses
for the joining country
GG
LL
Degree of economic integration
between the joining country and
the exchange rate area
The Extent of Intra-European
Trade
• Charles Engel and John Rogers
demonstrate the while of price
discrepancies decreased over the 1990s
(recall the Single Market Act of 1986), no
further price convergence happened after
the 1999 Euro’s introduction.
Single Currency and Trade
• Andy Rose suggested that on average,
members of currency union trade three
times more with each other than with
nonmember states. But Richard Baldwin
greatly scaled back to the Eurozone–
about 9 percent increase in mutual trade.
How mobile is Europe labor
force?
• The main barriers are not due to border
controls but to
• Differences in language and culture
• Government regulations—in EU workers
must establish their residence before they
qualify for unemployment insurance
• People changing region of residence in the
1990s: UK—1.7 percent of total
population; Germany—1.1 percent; Italy—
0.5 percent; US—3.1 percent (Huber
Asymmetric Macroeconomic
Shocks
In the first decade of the Euro nominal bond
rates converge but-• Inflation rates diverged
• Divergence in unemployment rates
• Divergences in growth rates
• Divergences in budget deficits