Transcript International Monetary Arrangements

Much Ado about EMU
Andrew K. Rose
Berkeley, Haas
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Beware Greeks Bearing Bonds
• Sovereign default was inevitable
– So far voluntary; “disorderly” to come?
• Current Greek 10-yr bond ≈20%
– German ≈1.5% (US, UK, Japan very low too)
• Government Debt unsustainable (≈150% GDP)
– German ≈ 80%
• Big government deficits (≈10% GDP) imply
continuing deterioration
– German ≈ 1%
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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 6: ESM approval implies unlimited ECB support
• European Monetary Fund (EMF) started July 2012
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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%, and
b) 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
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Hence More Fiscal Austerity
• Considerable pressure on Greece to raise
taxes, cut spending (and exacerbate 4-yr
recession)
– Portugal, Spain, Ireland too
– German View: Roasting the Meat (or Burning it?)
• But … will this work?
– The markets don’t think so
– Most commentators agree with markets
• Right way to approach the problem?
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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, and
2. There is a) little risk-sharing, and b) immobile
labor, then
3. 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
1999
2005
2006
2007
2008
2009
2010
2011
Real effective exchange rate (2005 = 100)
Germany
101.3
100.0
99.3
101.0
101.5
102.3
97.3
96.7
Greece
94.5
100.0
100.8
102.5
105.4
106.9
106.7
107.4
Italy
95.0
100.0
99.6
100.5
102.0
103.2
99.4
99.4
Portugal
92.7
100.0
100.5
101.8
102.7
102.1
99.9
100.8
Spain
90.9
100.0
101.5
103.2
106.1
106.3
103.7
104.3
Current account balance (% of GDP)
Germany
-1.3
5.1
6.3
7.5
6.2
6.0
6.2
5.7
Greece
-5.5
-7.6
-11.3
-14.6
-15.0
-11.2
-10.3
-9.8
Italy
0.7
-1.7
-2.6
-2.4
-2.9
-1.9
-3.5
-3.3
Portugal
-8.7
-10.3
-10.7
-10.1
-12.6
-10.9
-10.0
-6.5
Spain
-2.9
-7.4
-9.0
-10.0
-9.7
-4.8
-4.6
-3.5
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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 (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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