Much Ado about EMU Andrew K Rose Berkeley

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” 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% Andrew Rose, EMU 2

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 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, 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 Andrew Rose, EMU 4

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, 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; – 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%!) – 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 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% 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 (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 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 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 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 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 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 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 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 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 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 Andrew Rose, EMU 20

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 Andrew Rose, EMU 21