Transcript Powerpoint - Institute for European Studies

The European Economic Crisis:
Origins and Prospect for the Future
Andreas Hauskrecht
Kelley School of Business
Institute for European Studies
Indiana University
What Is the EMS?
• The European Monetary System was originally a
system of fixed exchange rates implemented in
1979 through an exchange rate mechanism
(ERM).
• The EMS has since developed into an economic
and monetary union (EMU),
a more extensive system of coordinated economic
and monetary policies.
– The EMS has replaced the exchange rate mechanism for
most members with a common currency under the
economic and monetary union.
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Membership of the
Economic and Monetary Union
To be part of the economic and monetary union,
EMS members must
1. first adhere to the ERM: exchange rates were fixed in
specified bands around a target exchange rate,
2. next follow restrained fiscal and monetary policies as
determined by Council of the European Union and the
European Central Bank,
3. finally replace the national currency with the euro,
whose circulation is determined by the European
System of Central Banks.
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Theory of Optimum Currency Areas
The theory of optimum currency areas argues that
the optimal area for a system of fixed exchange
rates, or a common currency, is one that is highly
economically integrated.
– economic integration means free flows of
• goods and services (trade)
• financial capital and physical capital
• workers/labor (immigration and emigration)
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Incentives to be a member of the Euro area
• Financing cost for government debt of
European countries were significantly higher
than for Germany. By joining the Euro these
countries lowered their government (and
corporate) by several percentage points,
which has significant positive impact on
economic activity (GDP growth).
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Decreased Bond Spread with Germany
-
Decreased Default Risk and Inflationary Risk
Governments able to refinance debt and borrow new capital cheaply
-
Italy specifically gained from this with their historically high debt
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Italy
5
4
3
Spain
2
Greece
1
Ireland
0
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
GER=0
-1
Official Introduction
of Euro
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Source: OECD
The costs of being a Euro member
• Before joining the euro area, many countries
had a history of higher inflation, rising wage
cost, and fiscal deficits, which undermined
their international competitiveness. Regularly
they used exchange rate corrections (a
depreciation of domestic currency) to restore
their international market position. By joining
the Euro, this instrument was given away.
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Bonanza
• After joining the Euro area the countries
enjoyed a Bonanza. Low cost to finance the
government debt, and significant inflows of
capital, which caused in some countries such
as Ireland and Spain, significant increases in
real estate prices and healthy GDP growth
rates.
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Convergence or Divergence
• Advocates of a monetary union expected main
macroeconomic variables in member
countries to converge. In particular:
– Inflation
– Productivity
– Labor cost
– Economic performance.
• And exactly the opposite happened.
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Slide 10
Unit Labor Cost
Unit Labor Output = ∆ Wages - ∆ Productivity
70.0
60.0
Unit Labor Spreads with Germany
(2000 =0)
50.0
Italy
40.0
Spain
30.0
20.0
Wrse
Greece
10.0
Ireland
GER=0 0.0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
-10.0
-20.0
-30.0
-40.0
Official Introduction of Euro
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Source: OECD
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Market reaction: Spreads with German
10 year Treasury Bond
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The Markets price in the possibility of
a government debt default
As a market reaction, government bond spreads
increased, which made it more and more
difficult for these countries to refinance their
government debt. Greece, Ireland, and Portugal
needed a bail out from the Euro member
countries and the IMF to avoid straight default.
But a financing of debt in itself, does not help
restore competitiveness.
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Digging the hole deeper and deeper
• The Nordic Euro member countries see the
problems of southern countries homemade.
Fiscal deficits, high debt burdens, unreasonably
high wages and benefits.
• So they asked for austerity policies for
precondition for bailouts.
• The so-called bail out programs by the IMF and
the European Union focused on helping financing
the debt payments, but not, or insufficiently cut
the overall debt burden.
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New Safety Architecture
• In September the European Stability
Mechanism (ESM) was founded with a budget
of Euro 500 billion, replacing earlier funding
facilities (EFSF, EFSM).
• The ECB will be in charge of supervising the
larger banks.
• A Banking Union is envisaged with the aim to
harmonize regulatory and supervisory
standards.
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Vicious Circle
• And the vicious circle began: cut in
government spending, recession, lower
government revenues, higher debt burdens,
new round of bailouts (Greece).
• The economies are shrinking, unemployment
increases, so does the government debt
burden.
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Sustainable Public Debt
• Sustainable defined are a constant or decreasing
debt/GDP ratio.
• The change in the debt/GDP ratio =
(real interest rate – real GDP growth rate)*(debt/GDP
from previous year)
+ (primary deficit/GDP from current year)
Even with a balanced budget (deficit=0) or a small
surplus, debt can be unsustainable is the real interest
rate is too high or the real GDP growth rate is too low!
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How does this work for Greece?
• Real interest rate to finance the government
debt: nominal interest minus inflation (plus
deflation) 10 + 1 = 11 percent
• Government debt end of 2012 157 percent
• Real growth rate: -3.2 percent (very optimistic)
• Primary budget: 0 percent
• 157 * .11 = 17.3 - -3.2 percent + 0.
• In other words the Greek government debt will
increase in 2013 by more than 20 percent, at
least
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Why not just bail them out once for all
• Why are the Nordic countries so hesitant to
run a big once for all bailout?
– The domestic tax payers show resistance;
– Moral hazard. Bail the out, and they do it again.
• So what can we expect for the future?
– Greece will very soon need a new rescue package
– Very likely, this will also be the case for Portugal.
– Also Spain and Ireland will have to ask for further
assist
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The Future
• However, refinancing debt payments will not
enable these countries to grow out of the
crisis.
• How long of a recession and high
unemployment can these countries sustain,
before political instability occurs or gets
worse.
• The crisis is not over yet.
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Floor opened
Q&A