11. EMU: Quo vadis ?

1. 11. EMU: Quovadis? The euro areagot into difficulties in the autumn of 2008 as a consequence of the globalfinancialcrisis, whichwasfirstinterpreted as a purely American ”subprimemortgage” crisis. Only as fromearly 2010 wasitbecomingobviousthat the euro areawouldbe a main arena for the financialcrisis. Three yearslater the crisishasspreadfromGreece to manyothercountries (the GIIPS) and itseffectsarefeltallover Europe (and beyond). Availableforecastsdonotsuggestanyrapidresolution of the crisis: • output is stilldeclining and unemploymentrising in mostcrisiscountries; • balancesheets of banksarestillweak and manybanksaround Europe arevulnerable; • governmentdeficitshavebeenreducedbutdebtlevelsrelative to GDP are in manycasesstillrising; • there is an aspiration to set up a bankingunionbutprogress is slow and itwillnotbe set up with such a speed as to help solve the currentcrisis; • debatecontinuesabout the properbalancebetweenadjustment (the austeritydebate), financing (by the ESM or via the ECB?) and privatesectorinvolvmentordebtrestructuring (with concernaboutdepositor capital flightbeingtriggered in countries at risk); • there is no ”magicalbullet” for such a multidimensionalcrisis as this: governmentdebtcrisis, bankingcrisis, macroeconomiccrisis, currentaccountcrisis, costcrisis, governancecrisis, politicalcrisis. Conceivablescenarios for the euro areadevelopmentinclude: - a prolonged ”muddlingthrough”, followed, in the end, by a morerobustdevelopment as structuralreformsareimprovinggrowthprospects in crisiscountries - exit of someminorcountrieswithout the EMU as a wholebeingthreatened - the strongcountriesleaving the euro, whichbecomes a weakcurrency - the weakcountriesexiting the euro, defaulting and causing a Europe-widebankingcrisis and depression (an economic and a politicalcatastrophy).

2. The exitissue The conceivableconsequences of an exitwouldobviouslydepend on which country exits and underwhatcircumstances. Thus: Grexit An exit of Greecehas at times and bymanyobserversbeenseen as a likelyscenario, butithasnothappened (mainlybecausenobodywants to take the decision?). Grexitwouldimply, inter alia: - a prolongedbankingholiday, capital controls, restrictions on taking out depositsfrombanks - introduction of a new drakhma, followedby a hugedepreciation and rapidinflation - conversion of deposits and assets/liabilitiesfrom euro into the new drakhma wheneverthis is legallypossible (that is, for assetsunderGreeklaw) - moratorium on mostdebtservice, becausemuch of the debt is denominated in the euro and cannotberedenominatedlegally (implying a hugerise in the value of debt in drakhma terms) - sharpfall in consumption and bankruptcies of manyordinarybusinessesdue to the difficulties of settingup a new paymentssystem (and evengetnotes and coins in circulation). For the euro area as a whole, Grexitneednothavesignificantconsequencesunlesstherewerecontagion to otherweakcountriesdue to the factthat the ”irreversibility” of the euro wouldbedemonstrated to be a myth. Exitof severalweakcountries (Club Medexit) ThiscouldbetriggeredbyGrexit, notablyifitwouldseemsuccesfulin restoringcompetitiveness and reducing the burden of debtservice (moratorium). Consequences: - samesort of bankingholiday and similareconomicconsequences and legaldifficulties as above (numerouslawcases with fightsaboutwhatredenomination is acceptable) - the defaulttriggeredbyexit (makingdebtserviceimpossible) wouldlead to a collapse of the bankingsystem in Europe and wouldtherebycause a Europe-wide depression - NB: the effectswouldbequitesimilarallover Europe, including in Sweden (giventhe importance of banking in Sweden).

3. (cont.) How aboutFixit? Exiting the euro is notattractive for Finland because: • The transitionalcosts of settingup a new paymentssystemwouldbe LARGE and the changeoverprocesschaotic • The legalproblems of redenominationareconsiderable • Itwouldgive no protectionagainst the main risk: a collapse of the euro • ItwouldnotsignificantlyreduceFinnishcommitments (certainlynotthosealreadyentered into) • The TARGET of the Bank of Finland in the ECB balanceis positive (money lost?) • The geopolitical status of Finland wouldsufferseriously A splitbetween North and Souht Heterogeneity of the euro area is the problem. A split into at leasttwomightseem the solution. However, exitby the South wouldcausedefaults and chaos. Exitby the North mightbeeasier: Northern Europe couldstartbyintroducing a virtualparallelcurrency (the ”hard” euro). Contractscouldbegraduallyredenominated into this new currency, whichcould in duetimealsoexist as notes and coins. The present and henceforth ”weak” euro woulddepreciaterelative to the hard euro, butthiswouldnotaffect the debtburden of the countriesremaining with the weak euro (as theirassets and debtswouldlargelyremaindenominated in the samecurrency). Technicallysuch a splitmightbeconceivable, politically is wouldpresumablybeperceived as a failure of ”Europe”. But the point is that the Northerncountrieshave a bargainingchip in the sense of a viablealternative and cannotthereforebepressuredby the Southern countriestoomuchagainstwhat is the politicalwill in the North and notably Germany. The enviseagedsplitwouldbeproblematic for Finland: join the soft South or the hard North (and riskfacingconsequences of a strongcurrency at the wrongtime)?

4. Rodrik’strilemma (adapted) National autonomy (fiscalpolicy) (presentconundrum) (as itused to be) Deep integration(EMU) (PoliticalDemocracy union) NB: generalizedcofinancingrisksunderminingdemocraticlegitimacy

5. ”The federalist vision of the trilemma” National budgetarysovereignty Common currencyEconomic (EMU)stability Comment: It is claimethat a ”currencywithout a state” is impossible, thatyoucannotcombinemonetaryunion with national budgetarysovereignty and national democracy. Ifso, then EMU is doomed, because the politicalpreconditions for a federation with significantcentralpowersdonotexist in Europe.

6. The trilemma and the Banking Union National ”bankingpolicy” Common currency Financial and economic (EMU) stability Comment: A common currencygoeshand in hand with integratedbanking and requires a common frameworkor ”bankingpolicy”, a bankingunion. There is also a need for a ”minimumfiscalbackstop”, the size and signficance of whichcanbemodest – ifregulation and supervision is tight and there is effective PSI (”bail in”).

8. Bottomline • The basicpolitical and economic case for EMU is open to question: maybesettingup the monetaryunionwasnot a great idea (perhapsevenbadorpremature); at least the design wasflawed (butthere is no counterfactual) • Presumably the flaws in the design havebeenidentified and theycanbecorrected, notablybysettingup the bankingunion (ifagreedupon and implementedcorrectly) • The euro is practically (almost) irreversible (evenifsomesmallmemberstatemightexit): a collapse of EMU wouldtrigger a political/economiccatastrophe; TINA applies? Consequence: Itmustbe made to work! • Financingwillincreasinglycomefrom the ECB, whereLatin Europe has a majoritythatcandecide to provide finance, ratherthanfrom the EMS, whereunanimity is required and wheredecisionscanbeblockedbyany (Northern) memberstate. • The crisispushescrisiscountries to a path of long-overduereforms? (cf. Finland and Sweden in the 1990s.) • The politicalcommitment to the EMU remainsstrong, including in Germany (butthere is a risk of social and politicalunrest in the crisiascountries). Also, the attractivity of defaultwillincreasewhen the primarybudget is in surplus (whenexternal finance is notneeded for currentexpenditure). • Muddlingthroughseemsrealistic, thoughitmaybe a prolonged and painfulprocess. • Finnishproverb: whatdoesnotkillyou, willstrenghtenyou (hopefullytrue).