Transcript EMU Presentation for Haas Advisory Board, February 2012

Much Ado about EMU
Andrew K. Rose
Berkeley, Haas
Andrew Rose , EMU
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Beware Greeks Bearing Bonds
• Sovereign default now inevitable
– Hopefully voluntary; otherwise “disorderly”
• Current Greek 10-yr bond >30%
– German ≈2% (US, UK, Japan 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”
• 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
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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
1. Institutions (easy)
– Central bank independence
2. Inflation (easy)
– CPI inflation within 1.5% of target;
– Target is average inflation of three countries with
lowest inflation
3. Interest Rates (easy)
– Average long-term interest rates within 2% of target;
– Target is average long-term interest rate of the three
low-inflation countries
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Convergence Criteria, 2
4. Exchange Rates (easy)
– Fixed Exchange Rates within “normal bounds” (15%!)
– No realignment within last two years
5. Fiscal Positions: 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
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Stability (and Growth) Pact
• EMU “Ins” should maintain deficits of less
than 3% GDP 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 3-yr
recession)
– Portugal, Spain, Ireland too
• 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 students) usually ask
two questions on EMU
– “Do European Countries look like an ‘Optimum
Currency Area’?” and
– “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 (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
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Possible Methods to Adjust (to
Asymmetric Business Cycles)
1. Sharing risks via public sector (system of
taxes and transfers)
– Or via private sector (international cross-holdings
of assets)
2. Factor mobility (unemployed workers move
to places of high demand)
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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
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Real Effective Exchange Rate (1999=100)
Germany
100.0
93.3
93.3
94.3
99.4
101.1
99.3
98.6
100.5
101.1
101.6
96.8
Greece
100.0
93.4
94.6
97.5
103.9
106.0
106.4
107.4
109.3
112.4
113.8
113.7
Portugal
100.0
97.6
100.0
102.5
107.2
108.5
108.5
109.1
110.8
111.7
110.9
108.6
Current Account Balance (% of GDP)
Germany
-1.3
-1.7
0.0
2.0
1.9
4.7
5.0
6.3
7.5
6.3
5.7
5.7
Greece
-5.4
-7.8
-7.2
-6.5
-6.6
-5.9
-7.5
-11.2
-14.3
-14.8
-11.0
-10.6
Portugal
-8.2
-10.4
-10.3
-8.2
-6.5
-8.4
-10.4
-10.7
-10.1
-12.6
-10.9
-9.9
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Bottom Line
• Greece has a fiscal problem
– But solving it (if possible) won’t restore growth
• Real problem: poor competitiveness limits
growth, employment
• No easy solution for that
• Hence … more serious crisis inevitable
– Could easily be worse than Lehman
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