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Much Ado about EMU

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Title: International Monetary Arrangements Author: Andrew Rose Last modified by: Microsoft account Created Date: 8/2/2010 12:53:16 PM Document presentation format – PowerPoint PPT presentation

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Title: Much Ado about EMU


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

2
Understanding the European Crisis
  • What are the risks of a European Sovereign Debt
    Crisis?
  • Financial Markets risks non-trivial but low
  • Currently (4/20) Greek 10-yr bond rate 13.3
  • Economic and Political Fundamentals remain poor
  • Recession ended, but growth slow, unemployment
    high
  • Syriza elected 1/2015 to end austerity
  • IMF, EC, Germans seem implacable
  • Whos Right? The Markets or the Fundamentals?

3
How can we understand the Euro Crisis?
  • What are the underlying causes?
  • Political, Economic, and Financial
  • Are the policy makers and markets correct in
    their diagnoses?
  • Probably Not
  • What are the potential implications for Europe
    and the rest of the world?
  • Potentially disastrous

4
Beware Greeks Bearing Bonds
  • Sovereign default was inevitable
  • So far voluntary disorderly to come?
  • Current Greek 10-yr bond 13 (way down)
  • German .1 (US, UK, Japan very low too)
  • Government Debt unsustainable (175 GDP)
  • German 75
  • Big government deficits gone now
  • Greek primary surplus before interest

5
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

6
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 and Portugal followed
  • European Stability Mechanism (ESM)
  • Permanent bailout kitty aka Firewall
  • Increased in late March 2012 to 500m, 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 2012 ESM approval implies unlimited
    ECB support, will do what it takes
  • European Monetary Fund (EMF) started July 2012
  • Banking Union (ECB at center) started Nov 2014
    single supervisor

7
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

8
Convergence Criteria, 1
  • Institutions
  • Central bank independence
  • Easy!

9
Convergence Criteria, 2
  • Inflation
  • CPI inflation within 1.5 of target
  • Target is average inflation of three countries
    with lowest inflation
  • Still easy!

10
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!

11
Convergence Criteria, 4
  • Exchange Rates
  • Fixed Exchange Rates within normal bounds
    (15!)
  • No realignment within last two years
  • Once more easy!

12
Convergence Criteria, 5
  • Fiscal Positions
  • Members must have Sustainable Government
    Financial Position defined as
  • Flow Deficit/GDP ratio of less than 3, and
  • 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

13
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, via Six
    Pack (2011) and surveillance in Two Pack (2012)

14
Hence More Fiscal Austerity
  • Considerable pressure on Greece to maintain/raise
    taxes, cut spending (after 5-yr recession!)
  • Portugal, Spain, Ireland too
  • German View Roasting the Meat (or Burning it?)
  • But will this work?
  • The markets arent panicked
  • Most commentators agree with markets
  • Right way to approach the problem?

15
How Should One Think about EMU?
  • Economists (and Haas MBA students) usually ask
    two questions on EMU
  • Do European Countries look like an Optimum
    Currency Area?
  • Are European Countries similar to American
    Regions?

16
Optimum Currency Areas
  • Mundells Nobel Idea When are two regions more
    likely to gain from common currency?
  • If they share deep trade links and
  • Single currency reduces transaction costs of
    trade
  • If they have similar business cycles
  • Same monetary policy appropriate

17
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

18
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)

19
An Alternative Adjustment Method
  • Factor Mobility
  • Unemployed workers move to places of high demand
  • Relieves unemployment and inflation

20
Mundells Optimum Currency Area
  • Suppose business cycles are asymmetric, and
  • There is a) little risk-sharing, and b) immobile
    labor, then
  • 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)

21
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

22
Competitiveness within EMU
1999 2005 2008 2009 2010 2011 2012 2013
Real effective exchange rate (2010 100) Real effective exchange rate (2010 100) Real effective exchange rate (2010 100) Real effective exchange rate (2010 100) Real effective exchange rate (2010 100) Real effective exchange rate (2010 100) Real effective exchange rate (2010 100)
Germany 101.3 100.0 101.5 102.3 97.3 96.5 93.0 94.5
Greece 94.5 100.0 105.4 106.9 106.7 107.5 104.1 103.2
Portugal 92.7 100.0 102.7 102.1 100.0 100.8 99.5 99.8
Spain 90.9 100.0 106.1 106.3 103.7 104.3 102. 101.2
Current account balance ( of GDP) Current account balance ( of GDP) Current account balance ( of GDP) Current account balance ( of GDP) Current account balance ( of GDP) Current account balance ( of GDP) Current account balance ( of GDP)
Germany -1.3 5.1 6.2 6.0 6.3 6.2 7.0 8.0
Greece -5.5 -7.6 -15.0 -11.2 -10.3 -9.9 -3.5 -.7
Portugal -8.7 -10.3 -12.7 -11.0 -10.0 -7.1 -1.6 -3.0
Spain -2.9 -7.4 -9.7 -4.8 -4.6 -3.5 -1.1 -1.9
Unemployment Rate Unemployment Rate Unemployment Rate Unemployment Rate Unemployment Rate Unemployment Rate Unemployment Rate Unemployment Rate
Germany 8.4 11.1 7.5 7.7 7.1 5.9 5.2 5.1
Greece 11.7 9.8 7.7 9.5 12.5 17.7 27.6 26.7
Portugal 4.4 7.6 7.6 9.5 10.8 12.7 15.6 15.3
Spain 15.6 9.2 11.3 18.0 20.1 21.6 26.0 26.0
23
Bottom Line
  • Greece has a fiscal problem
  • But solving it (if possible) wont restore growth
  • Difficult to sustaining pro-cyclic fiscal policy
  • Real problem poor competitiveness limits growth,
    employment (Portugal, Spain too!)
  • Bubble overhangs also
  • No easy solution for that
  • Hence more serious crisis inevitable
  • Could easily be worse than Lehman
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