Much Ado about EMU Andrew K Rose Berkeley

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Much Ado about EMU Andrew K. Rose Berkeley, Haas Andrew Rose , EMU 1

Much Ado about EMU Andrew K. Rose Berkeley, Haas Andrew Rose , EMU 1

Beware Greeks Bearing Bonds • Sovereign default was inevitable – So far voluntary; “disorderly”

Beware Greeks Bearing Bonds • Sovereign default was inevitable – So far voluntary; “disorderly” to come? • 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% Andrew Rose, EMU 2

How Could This Happen? • Article 103 (“No Bail-Out”) Maastricht Treaty – “… neither

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 Andrew Rose, EMU 3

Evolving E-Bailout Institutions • European Financial Stabilization Mechanism (EFSM) – EC funds (from EU

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 Portugal followed • European Stability Mechanism (ESM) – Permanent bailout kitty aka “Firewall” – Increased in late March 2012 to € 500 m, starts 7/2012, fully ready by 2014 (!) – Probably still too small (German objections; France + others wanted € 1 tn – EFSF + ESM limit is € 700 bn • European Monetary Fund (EMF) starts July 2012 Andrew Rose, EMU 4

How Did We Get Here? • Important to Understand Membership Requirements for EMU •

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 Andrew Rose, EMU 5

Convergence Criteria, 1 Institutions – Central bank independence – Easy! Andrew Rose, EMU 6

Convergence Criteria, 1 Institutions – Central bank independence – Easy! Andrew Rose, EMU 6

Convergence Criteria, 2 Inflation – CPI inflation within 1. 5% of target – Target

Convergence Criteria, 2 Inflation – CPI inflation within 1. 5% of target – Target is average inflation of three countries with lowest inflation – Still easy! Andrew Rose, EMU 7

Convergence Criteria, 3 Interest Rates – Average long-term interest rates within 2% of target;

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! Andrew Rose, EMU 8

Convergence Criteria, 4 Exchange Rates – Fixed Exchange Rates within “normal bounds” (15%!) –

Convergence Criteria, 4 Exchange Rates – Fixed Exchange Rates within “normal bounds” (15%!) – No realignment within last two years – Once more: easy! Andrew Rose, EMU 9

Convergence Criteria, 5 Fiscal Positions • Members must have “Sustainable Government Financial Position” defined

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 Andrew Rose, EMU 10

Stability (and Growth) Pact • EMU “Ins” should maintain deficits of less than 3%

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 Andrew Rose, EMU 11

Hence More Fiscal Austerity • Considerable pressure on Greece to raise taxes, cut spending

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? Andrew Rose, EMU 12

How Should One Think about EMU? • Economists (and Haas MBA students) usually ask

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? ” Andrew Rose, EMU 13

“Optimum Currency Areas” • Mundell’s Nobel Idea: When are two regions more likely to

“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 Andrew Rose, EMU 14

But if Two Regions have Asymmetric Business Cycles … • Need to be able

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 Andrew Rose, EMU 15

One Way to Adjust (to Asymmetric Business Cycles) • Sharing risks – System of

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) Andrew Rose, EMU 16

An Alternative Adjustment Method • Factor Mobility – Unemployed workers move to places of

An Alternative Adjustment Method • Factor Mobility – Unemployed workers move to places of high demand – Relieves unemployment and inflation Andrew Rose, EMU 17

Mundell’s “Optimum Currency Area” 1. Suppose business cycles are asymmetric, and 2. There is

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) Andrew Rose, EMU 18

Fiscal Austerity is not the Solution • It solves a different problem • Greek

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” Andrew Rose, EMU 19

Competitiveness within EMU 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

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 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. 5 109. 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 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. 7 -10. 1 -12. 6 -10. 9 -9. 9 Andrew Rose, EMU 20

Bottom Line • Greece has a fiscal problem – But solving it (if possible)

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 Andrew Rose, EMU 21