Transcript The euro crisis: Where to from here?

The euro crisis: Eight mistakes
Jeffrey Frankel
Harpel Professor of Capital Formation and Growth
Harvard Kennedy School
State of the Euro
Center for European Studies
September 22, 2015
1. The membership should not have been
expanded so quickly after 1999.
– 19 countries is too many to pass the OCA test.
– In particular, Greece was not in truth ready
to be admitted as early as 2001.
2. The fiscal rules had no credibility.
• The SGP was violated routinely even in boom years
(2002-07).
• Thus the moral hazard problem, though correctly
identified, had not been effectively addressed.
• Declarations of more severe rules did not help:
• When governments received letters from Brussels
informing them that their budget deficits exceeded the
ceilings and needed to be corrected, they would
invariably respond with optimistic forecasts that strong
growth would soon bring the deficits back down.
E.g., even though true Greek budget deficits in most years
were far in excess of the supposed limit (3% of GDP),
the official budget forecasts were always rosy.
Until, in 2009, the bottom fell out of the budget.
Source: Frankel & Schreger (2011)
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3. Warning signs were misinterpreted
(1999-2007)
• It was viewed as a good thing rather than bad…
– …when net capital flowed copiously to Greece and
other periphery countries after joining the euro
– …when their interest rate spreads fell almost to zero,
this was viewed as good rather than bad.
• But low spreads were direct real-time evidence
the moral hazard problem had not been solved.
– After all, the ECB accepted their bonds as collateral.
Periphery-countries’ interest rates converged to Germany’s
after they joined the euro => investors perceived no default risk.
Given the high debts, the ECB must have been seen as standing behind them.
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4. Monetary policy was too tight, 2008-12
• The ECB made a mistake raising the interest rate July 2008
– just as the global financial crisis was hitting,
– in a mistaken attempt to keep CPI inflation low.
• Northern Europe must tolerate some inflation and euro
depreciation,
– for the periphery countries to bring down relative labor costs
without undergoing outright deflation.
• ECB policy became more appropriate
after Mario Draghi took over in 2011
– especially the “do whatever it takes” speech in July 2012
– and QE in January 2015.
5. Greece should have been
sent to the IMF early in the crisis.
• The need for the IMF should have been clear
in January 2010.
• Rather than going into shock, leaders in
Frankfurt & Brussels could have welcomed the
Greek crisis as a useful opportunity to
establish a precedent for the long-term life of
the euro.
6. More of the debt
should have been written down earlier
• It should have been done when most of the
debt was still held by private creditors.
– They could usefully have taken a “haircut,”
– which is harder for public sector creditors
(particularly the IMF, ECB, ESFS and ESM).
– It would have addressed the moral hazard problem.
• But again, leaders insisted in 2010 & 2011 that
writing down the debt was unthinkable.
7. Some (esp. in Germany), denied that
fiscal austerity is contractionary.
Source: P.Krugman, 10 May 2012,
As a result of austerity, debt/GDP ratios continued to rise sharply:
Declining GDP outweighed progress on reduction of budget deficits.
200
Public Debt (% GDP)
180
160
France
Germany
Greece
Ireland
Italy
Portugal
140
120
100
80
60
40
Spain
20
0
.
From Rémi Bourgeot, Fondation Robert Schuman
Data source: IMF WEO (October 2014).
8. Tsipras misperceived the game.
• When the Syriza government came to power in
January 2015, the new PM had the chance to play
a role analogous to Korean
President Kim Dae Jung in 1997.
• He grossly over-estimated
Greece’s bargaining power.
• A good bargain would have included:
– (i) an explicit rejection of big primary budget surpluses
– (ii) but serious structural reform instead, and
– (iii) an implicit understanding with the creditor agencies
that they would roll over the debt.
More graphs…
The Greek budget deficit in truth never
came below the 3% of GDP ceiling. Nor did the debt/GDP ratio
(≈100%) ever decline in the direction of the 60% limit.
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The Competitiveness Problem (1999-2013)
During the euro’s first decade, wages & ULCs
rose faster in the periphery than in Germany.
160
Nominal Unit Labor Costs (1999=100)
Italy
Ireland
France
Austria
Spain
Euro area
Portugal
Greece
150
140
130
120
110
100
90
1999
2001
2003
2005
2007
2009
From: Rémi Bourgeot, Fondation Robert Schuman. Source: Ameco, EC.
2011
2013
Germany
Big current account deficits in periphery countries
up to 2008 were seen as benign reflections of optimizing
capital flows, instead of as warning signals.
10
Current Account (% GDP)
5
Germany
Ireland
Italy
Portugal
Greece
Spain
0
-5
-10
-15
France
-20
Source: Rémi Bourgeot, Fondation Robert Schuman
Data: IMF WEO (October 2014)
The bigger the fiscal contraction, the bigger the GDP loss
relative to what had been officially forecast in early 2010
=> true multipliers > than multipliers that IMF had been using.
Europe: Growth Forecast Errors vs. Fiscal Consolidation Forecasts
Source: Olivier
Blanchard &
Daniel Leigh,
2014, “Learning
about Fiscal
Multipliers
from Growth
Forecast Errors,”
fig.1, IMF Economic
Review 62, 179–212
Note: Figure plots forecast error for real GDP growth in 2010 and 2011 relative to forecasts made in the spring
of 2010 on forecasts of fiscal consolidation for 2010 and 2011 made in spring of year 2010; and regression line.
Interest rates on periphery bonds came back down
after Mario Draghi took office in Nov.2011.
LTROs
-- Dec.2011 & Feb.2012
“Within our mandate,
the ECB is ready
to do whatever
it takes to
preserve the
euro.
And believe me,
it will be enough.”
-- July 2012
Source: Jeffrey Anderson and Jessica Stallings, IIF, Feb. 13, 2014,
OMTs -- Aug.2012
Spreads in the periphery came back down after
Draghi said in 2012 he would “do what it takes.”
The periphery countries had by 2013
managed to reverse much of the run-up in costs
(except Italy)
Source: Jeffrey Anderson & Jessica Stallings, “Euro Area Periphery: Crisis Eased But Not Over,” IIF 2/13/14.
But periphery economies remain weak
Source: Jeffrey Anderson and Jessica Stallings, Feb. 13, 2014, “Euro Area Periphery: Crisis Eased But Not Over,” Institute of International Finance, Chart 3
Unemployment in the periphery remains high
Source: Jeffrey Anderson and Jessica Stallings, Feb. 13, 2014 , “Euro Area Periphery: Crisis Eased But Not Over,” Institute of International Finance, Chart 1
Unit Labor Costs
have come down
…at the cost of still-high unemployment.
slowly…
Carlos De Sousa & Guntram Wolff, 1 Oct., 2012, Breugel
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Adjustment in the periphery is that much harder
when eurozone-wide inflation < 1%.
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Unit Labor Costs Updated (1999-2014)
115
Real Unit Labor Costs (1999=100)
Italy
France
110
Ireland
105
Euro area
100
Greece
95
Germany
Austria
90
Spain
85
1999
2001
2003
2005
2007
2009
2011
2013
Portugal
Source: Ameco, EC; own calcuations
Rémi Bourgeot, European Issue n°289, Fondation Robert Schuman, 9/23/13.
“Labour Costs and Crisis Management in the Euro Zone: A Reinterpretation of Divergences in Competitiveness.”
updated 1/7/2015