6. EMU: the first decade ( when all went well – or at least seemed to do so )

1. 6. EMU: the firstdecade(whenallwentwell – or at leastseemed to doso) 6.1 Heterogeneity 6.2 Effects of lowinterestrates 6.3 Changes in competitiveness: causes and consequences 6.4 Monetarypolicy 6.5 Public finances and fiscalpolicy 6.6 Output and employment

2. 6.1 Structuralcharacteristics of EU somecountriesm (ranks in brackets) The Nordicsgethighscores for the rule of law, the school, economicfreedom and creativity; Southern Europe scoreslesswell Rule of law1 School 2 Economicfreedom3 Creativityindex4 GDP per capita5 Employmentrate6 AUT BEL DEN FIN FRA GER GRE IREITA NET POR SPA UKM SWE 1.80 1.40 1.88 1.97 1.52 1.63 0.62 1.76 0.38 1.81 1.04 1.19 1.77 1.95 (5) (10) (3) (1) (9) (8) (13) (7) (14) (4) (12) (11) (6) (2) 496 515 503 511 497 513 466 487 483 526 487 483 492 494 (7) (3) (5) (1) (6) (4) (14) (10) (12) (2) (10) (12) (9) (8) 70.3 69.0 76.2 72.3 63.2 71.0 55.4 76.9 58.8 73.3 63.0 69.1 74.1 71.7 (8) (10) (2) (5) (11) (7) (14) (1) (13) (4) (12) (9) (3) (6) 0.663 0.813 0.878 0.894 0.764 0.764 0.638 0.805 0.707 0.854 - 0.744 0.789 0.923 (12) (5) (3) (1) (8) (8) (13) (6) (11) (4) (10) (7) (1) 126 119 127 115 108 118 90 128 101 133 80 100 112 123 (4) (6) (3) (8) (10) (7) (13) (2) (11) (1) (14) (12) (9) (5) 72.1 61.9 73.1 69.0 63.8 72.5 55.6 59.2 56.9 74.9 64.2 57.7 69.5 74.1 (5) (10) (3) (7) (9) (4) (14) (11) (13) (1) (8) (12) (6) (2) 1 Oikeusvaltioindeksi (Rule of Law). Lähde: Maailmanpankki . 2PISA-tutkimus, matemaattinen osaaminen. Lähde: OECD. 3 Index of EconomicFreedom. Lähde: Heritage-säätiö. 4 Richard Florida, University of Toronto, the Martin Prosperity Institute. 5 BKT henkeä kohti ostovoimapariteetilla arvioituna. Lähde: Euroopan komissio. 6 Työllisyysaste 15–64 -vuotiaat. Lähde: Eurostat.

3. Structuralcharacteristics of someEU-countries (cont.) Incomedistribution1 Child poverty2 Trust3 Happiness4 Excessivefatness5 Drinking of the young6 Itävalta Belgia Tanska Suomi Ranska Saksa Kreikka IrlantiItalia Hollanti Portugali Espanja Englanti Ruotsi 0.265 0.269 0.248 0.263 0.293 0.295 0.321 0.299 0.337 0.294 0.361 0.309 0.341 0.259 (4) (5) (1) (3) (6) (8) (11) (9) (12) (7) (14) (10) (13) (2) 14.3 18.3 10.9 11.4 18.4 17.5 23.0 19.7 24.7 13.7 22.4 26.2 20.3 13.1 (5) (7) (1) (2) (8) (6) (12) (9) (13) (4) (11) (14) (10) (3) 70.2 63.0 131.9 117.5 37.9 75.8 54.6 72.1 60.8 90.6 21.9 40.9 61.7 134.5 (7) (8) (2) (3) (13) (5) (11) (6) (10) (4) (14) (12) (9) (1) 7.7 7.3 7.9 7.8 7.0 7.4 7.0 7.5 7.1 7.7 7.1 7.0 7.4 7.9 (3) (8) (1) (2) (12) (6) (12) (5) (9) (3) (9) (11) (6) (1) 12.4 12.7 11.4 14.3 10.5 13.6 21.9 13.0 10.2 11.3 12.8 14.9 24.0 10.7 (6) (7) (5) (11) (2) (10) (13) (9) (1) (4) (8) (12) (14) (3) 23.0 17.5 31.5 28.0 14.3 18.0 13.0 21.0 12.5 15.0 15.0 18.5 32.5 16.0 (11) (7) (13) (12) (3) (8) (2) (10) (1) (4) (4) (9) (14) (6) The Nordicsscorewell in terms of equality, trust and happiness – butFinnsarefat and drinktoomuch 1 Gini-kerroin, joka saa arvon 0, jos tulonjako on täysin tasainen ja arvon 1, jos täysin epätasainen. Lähde: OECD. 2 Osuus alle 18-vuotiaista, joiden perheiden tulot ovat alle 60 % mediaanituloista. Lähde: Eurostat. 3 Osuus vastaajista, jotka katsovat voivansa luottaa kanssaihmisiin. Lähde: World ValuesSurvey. 4 Tyytyväisyys omaan elämäänsä. Lähde: World Poll Gallup. 5 Osuus joiden BMI > 30, jossa BMI = paino/pituuden neliö. Lähde: OECD. 6 Toistuvasti itsensä humalaan juovien nuorten osuus. Lähde: OECD.

4. 6.1 Structuralindicators: Anglo-Saxons and Nordicsare ”liberal”, Central and South Europeansarenot – but the situation is changingbecause the crisishastriggered a lot of reforms in the countriesconcerned! PMR KOF UK NL SE FI GR BE IE DK FR AT FR BE IT PT SE PT IT AT DE FI DE ES DK IE NL UK GR ES EPL FRA PMR = Product market regulation EPL = Employment protection legislation KOF = Globalisation index (trade and capital) FRA = Fraser economic freedom index

5. 6.2 Effects of lowinterestrates: creditexpansion, houseprices, domesticdemand • Joining the EMU brought with itsignificantlylowerinterestrates for a number of memberstates (GRE, POR, IRE, SPA, ITA, also FIN) • The rapidconvergence of nominalinterestrates, includingbondyields on long-termgovernmentbonds, had the consequencethatrealinterestrateswerelower the higher the rate of inflation (cf. the ”Walter’scritique”) • Lowrealinterestrateshavebeenassociated with rapidcreditexpansion • Rapidcreditexpansionhasbeenassociated with big increases in houseprices (implying a risk of a bubble) • Lowrealinterestrates and rapidcreditexpansionhavealsobeenassociated with a largecumulativeincrease in realgrowth of domesticdemand

6. 10 yeargovernmentbondyields Interestratespreads (differences) used to berather big because of inflationdifferentials and exchangerateexpectations. EMU largelyeliminatedsuchexpectations. Recentlyspreadshavebeencausedby the risk of default of governments. Greece Italy Spain Irland Finland Germany 1995 2000 2005 2010

7. Real rate of interest and inflation 1999-2008Inflation = averageconsumerpriceinflationReal interestrate = 10 yeargovernmentbondyieldlessinflation as definedabove Real interestrateswerehigher the lower the rate of inflation and viceversa – presumably the opposite to whatwouldhavebeencalled for! Finland Austria Germany Denmark France Belgium Italy Netherlands Real interestrate Greece Portugal Spain Irland Inflation

8. Real rate of interest and creditexpansion 1999-2008realrate of interest = 10 yeargovernmentbondyieldlessconsumerpriceinflationcreditexpansion = averageincrease in stock of outstandingbankloans Lowrealinterestratesgohand in hand with rapidcreditexpansion Greece Irland Spain Finland Italy Credit expansion Belgium Portugal France Netherlands Austria germany Real rate of interest

9. Credit expansion and housingprices 1999-2008creditexpansion = averageincrease in stock of banklendinghousingprices = cumulativeincrease in housingprices Rapidcreditexpansiontends to gohand in hand with rapidlyrisinghouseprices. Spain Irland France Belgium Netherlands Greece Housingprices Finland Italy Portugal Austria Germany Credit expansion

10. Credit expansion and domesticdemand 1999-2008creditexpansion = avergaeincrease in stock of bankloansdomesticdemand = averageannualgrowth of domesticdemand Rapidcreditexpansionalsofuelles a rapidrate of growth of domesticdemand (privateconsumption plus investment). Irland Spain Greece Finland Domesticdemand France Netherlands Portugal Belgium Austria Germany Italy Credit expansion

11. Unitlaborcost 1998-2008unitlaborcost of the wholeeconomy, index, 1998 = 100 Rapidgrowthwasassociated with rapidlyrisingunitlaborcosts Irland Spain Italy Portugal Greece France Finland Germany

12. Housingprices 1999-2013’index, 1999/1 = 100 Whatgoesupmayalsocomedown Irland Finland Spain Italy Greece Portugal germany 1999 2002 2005 2008 2011

13. 6.3 Changes in competitiveness: causes and consequences • stronggrowth in domesticdemandtends to raisecostdevelopmentsweakeningcompetitiveness (measured as relativeunit labour costs in a common currency, relative to a weightedaverage of competitorcountries) • Weakeningcompetitivenessriskslead to slowergrowth in exports • Also, itmay show up as a deterioration of externalbalance, that is a decrease in the currentaccountsurplus (or an increase in the deficit) • Such a weakening of externalbalance (decrease in exportsand/orincrease in imports) is bad for economicgrowth • Itmayalsobeindicatingthat the privatesector is gettingexcessivelyindebted • Whileitmaybeeasilyfinanced as long as bankscanfreelyincreasetheirnetdebt to the ECB, itmaycausefinancingproblemsifbankshave a lack of high-qualitycollateral to backtheirborrowingfrom the ECB

14. Competitiveness and the currentaccount (% of GDP),changesfrom 1998 to 2008 There is a reasonablyclear association of externalbalance (the currentaccount) and competitiveness (relativeunit labour costs in a common currency)

15. Summary of the preceding • Nominalinterestratesdeclinedsignificantly in Southern Europe uponjoining the EMU, butinflationremainedhigherthanelsewhere, sorealinterestrateswerecomparativelylow • Lowrealinterestrateswereassociated with rapidcreditexpansion, rapidincreases in houseprices and rapidgrowth of domesticdemand • Rapidgrowth of domesticdemandwasassoicated with relativelyhighwage and costincreasesleading to increases in relativeunit labour costs • Loss of competitivenessshowedup in weakerexports and notably in a negativedevelopment of the currentaccount; the deficit on the currentaccountincreasedsignificantly in allthosecountriesthatlaterhavecome to beidentified as the crisiscountries

16. 6.4 Monetarypolicy of the ECB (measuredby the short-terminterestrate) and the cycle (output cycle) 1 2 Pricestabilityhasprevailed (with inflationmostlysightlyabove 2 %) and the ECB hassystematicallypursued a countercyclicalmonetarypolicy. 1Lyhyt korkotaso. 2 Tuotannon poikkeama potentiaalisesta tasostaan, %. Lähde: Euroopan komissio.

17. Monetarypolicy and the cycle: US Fed) 1 2 The US Fedhasalsopursued a countercyclicalmonetarypolicy, and ithastypicallytakenstronger action than the ECB. 1Short-terminterestrate. 2Deviation of GDP fromitspotentiallevel, %. EuropeanComission.

18. 6.5 Public finances and fiscalpolicy • Almostallmemberstateshavequiteoftenrunbudgetdeficits (general governmentfinancialdeficits) above 3 per cent of GDP and hadgrosspublicdebtsabove 60 per cent of GDP, whichnormallyamounts to a violation of the Stability and GrowthPact and the ExcessiveDeficitProcedure • Manymemberstateshavealsobeenrunningprocyclicalfiscalpolicies, that is, policieshavebeenexpansionary in booms and contractionary in recessions, therebyadding to economicinstability • One reason for procyclicalpolicies is that a favourablecyclicalsituationincreasestaxrevenues (and reducesspending on unemployment), and politiciansareeager to spend the extrarevenues, makingitmoredifficult to allow the budget to weaken in the nextrecessioin. • Anotherreason for procyclicality is that the debt and deficitmaybetoo big to allow for countercyclicalexpansionarypolicies in a recession (due to lack of confidence in the financialmarket); thus, the governmentmayhave no choicebut to tightenfiscalpolicy in the recessionbecause of the fall in taxrevenues (and the increase in spending on unemployment). • Notabenethat big deficitsmaybe a source of problems (notleastbyreducingconfidence in policies), butarealso a consequence of economicdevelopments, i.e. a deeprecessionalmostinevitablyincreases the budgetdeficit (byreducingtaxreveneus and adding to cyclicalexpenditureitems)

19. General governmentfinancialbalances, % of GDP

20. Gen. gov. grossfinancialdebt, % of GDP

21. Fiscalpolicy and the cycle: the euro area The fipo-indicator (the change in the cyclicallyadjustedbudgetbalance) and the output gaptypicallygo in oppositedirections, whichillustratesprocyclicalfiscalpolicy, that is, policythat is expansionaryduringgoodtimes and contractionaryduringbad. However, policyhasbeencountercyclicalsince 2007.

22. Fiscalpolicy and the cycle: Finland (output gap and change in cyclicallyadjusted gen. gov. Balance) Fiscalpolicyhasbeenrathersystematicallycountercyclical in Finland, butchanges in policyhavetypicallybeenrathermodest.

23. Fiscalpolicy and the cycle: Greece Fiscalpolicyhasbeensystematicallyprocyclical in Greece. Someslighteasing in 2008-2009 constitute an exception, thathad to bereversed with significanttightening as from 2010 because of the unsustainablepublicfinances

24. Fiscal policy and consolidation 1999-2008 aCorrelation coefficient of output gap and fiscal impulse measured by change in cyclically-adjusted budget balance, % of GDP b General Government financial balance on average in 1999-2008, % of GDP Source: OECD Economic Outlook No. 86, November 2009

25. EMU: the firstdecade Commissionar of Economic and MonetaryAffairsJoaquinAlmunia: ”A fulldecadeafterEurope’sleaderstook the decision to launch the euro, wehavegoodreason to beproud of the single currency. The Economic and Monetary Union and the euro are a majorsuccess. For itsmembers, EMU hasanchoredmacroeconomicstability, and increasedcrossbordertrade, financialintegration and investment. For the EU as a whole, the euro is a keystone of furthereconomicintegration and a potentsymbol of ourgrowingpoliticalunity. And for the world, the euro is a major new pillar of the international monetarysystem and a pole of stability for the globaleconomy.” (EMU@10 – Successes and challenges of Economic and Monetary Union, EuropeanEconomy, 2/2008) With the benefit of hindsight, thischaracterizationdoesnotquitehit the nail. In fact, a housingbubblewasbuilding, publicfinanceswerestructurallygettingweaker, seriousreformswerenotundertaken, competitivenesswaseroded in weakcountries, vulnerability to anyshockwasbecomingevermoreserious – and all of thiswasneglected in an atmosphere of complacencyoreveneuphoria!