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Fragile Eurozone 2013

Fragile Eurozone 2013 . The Fundamental Trilemma. Country can choose only two the three objectives: fixed exchange rate, open financial markets, or monetary independence:

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Fragile Eurozone 2013

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  1. Fragile Eurozone 2013

  2. The Fundamental Trilemma Country can choose only two the three objectives: fixed exchange rate, open financial markets, or monetary independence: • Country can have fixed exchange rate and retain monetary policy. But this would require maintaining controls on financial flows. - China today and early Bretton Woods; 2. Country can leave financial movements free and retain monetary autonomy, but only by letting the exchange rate fluctuate. - Eurozone, Japan, UK, US 3. Country can have open financial markets and stabilize the currency, but only by abandoning monetary policy as countercyclical tool. - Argentina yesteryear, individual countries of Euroland, Hong Kong

  3. The Small Mundell-Fleming Economy with Fixed Rates Goods market Same as before but with fixed exchange rate (R*) (Expfx) Y = C(Y - T) + I(rd) + G + NX(R*) Financial markets Monetary policy equation in small open economy with risk premium (σ). (MP$) rd = rw+ σ Substituting MP$ into Expfx: (IS$fx) Y = C(Y - T) + I(rw+ σ) + G + NX(R*) In Eurozone, real exchange rates only move with domestic prices. R = e*pd/pf So the evolution of competitiveness depends upon relative inflation (or production costs).

  4. Cases to think about • Fiscal policy • Monetary policy • Divergent inflation in Eurozone • Financial shocks or risk premia for southern Europe in Eurozone

  5. OPEN ECONOMY rd Equilibrium rw+σ MP$fx C+I(rw+σ)+G+NX(R*) (IS$fx) Y CF CF

  6. Fiscal policy rd rw+σ MP$fx (IS$fx) (IS$fx)’ Y CF CF

  7. Monetary Policy rd rw+σ MP$fx (IS$fx) Y CF CF

  8. Results with Fixed Rates are Reverse of Flexible Rates! • Fiscal policy super-effective • Monetary policy super-ineffective • Like a liquidity trap!

  9. History of Eurozone • Gold standard through 1914, suspended WW I, reinstated 1920s. • Long civil war in Europe (1914 – 1945). • Gold standard deepened the Great Depression • Reconstruction with Bretton Woods system (1945- 1971) • European leaders desired economic and political integration to reduce prospect of future wars • Common Market and European Community (1958 – 1993) • European Monetary System (1978 - 1988): fixed rates of major countries • Delors plan for monetary union (1989) • Eurozone established with irrevocable fixing of rates (2001) • EZ adopted by 17 countries as of 2013 • Divergent wage trends led to growing imbalances after 2001 • World financial crisis 2008 weakened public finances • Eurozone crisis begins in Ireland, spreads to Greece, then to Italy • According to Euroskeptics, the end of the Eurozone is nigh…

  10. Eurozone 2013

  11. Costs and adjustment in Eurozone • Because e is fixed, only adjustment by relative prices (pd/pf). • We can see the growing divergence by looking at unit labor costs (ULC). ULCi = wi/(Productivityi) • Next slide shows how south because increasingly uncompetitive, real appreciation. • Led to German R depreciation, big current account surplus, boom; opposite in the South. • Major issue of EZ is that only options for adjustment are inflation in the north or prolonged high unemployment and deflation in the south.

  12. Unit labor costs relative to EZ average (1998 = 1)

  13. Inflation in Italy, raising R, lowering NX, Y rd rw+σ MP$fx (IS$fx) (IS$fx)’ Y CF CF

  14. Unstable dynamics See Romer reading. Good example of “bad equilibrium, good equilibrium” like bank runs (here, runs on countries whose liabilities are in foreign currencies). Why is Spain in trouble but not UK?

  15. Romer debt model Basic ideas: • This is the run on the bank as applied to countries. • Basic idea is that have an instability because of the impact of risk on country interest rates (rd = rw + σ). • Two equilibria: good (full employment) and bad (default) Assumptions: • Government has debt of D and default probability π. • Governments have a random tax revenue, T, with cdfF(T). • Interest: • When T < RD, the government defaults

  16. Math of Romer model • Investor equilibrium: • Government default occurs when T < RD, which has a cdf (cumulative distribution function): • We have two equilibrium equations in R and π.

  17. π (prob. of default) 1 Investors 0 R (interest factor)

  18. π (prob. of default) 1 Government and taxes 0 R (interest factor)

  19. π (prob. of default) 1 Investors Government and taxes 0 R (interest factor)

  20. π (prob. of default) Three equilibria 1 Investors Government and taxes 0 R (interest factor)

  21. π (prob. of default) UNSTABLE DYNAMICS 1 Investors Government and taxes 0 R (interest factor)

  22. π (prob. of default) Simplified if T is given 1 Government and taxes Investors 0 R (interest factor)

  23. Greece: before and after the run • Viewed as riskless until financial crisis • Risk first perceived in financial crisis (1) • October 2009: Greek fiscal situation announced much worse (2) • Fall 2009: Greek debt downgraded • Early 2010: Greek asks for voluntary default (3) 3 2 1

  24. Italy: before and after the ECB intervention • Viewed as riskless until financial crisis • Deterioration as Euro crisis progressed (1) • Spiral toward bad equilibrium (2) • July 2012: ECB announced it will “do whatever it takes” to save Eurozone (3), leading to improvement (movement toward good equilibrium) 3 2 1

  25. Increased risk, raising rd rd MP$fx’ rw+σ MP$fx (IS$fx) Y CF CF

  26. Summary on Romer model • Another example of a runs model with two equilibria • Can help understand why: • Some countries are crisis-prone • How a rescue operation can move country to a good equilibrium

  27. Options for Eurozone • Rapid Growth of Eurozone • ECB lowers rates, Euro depreciates, Germany expands • Problem: in liquidity trap, almost out of bullets 2. Long Recession to Restore Periphery Competitiveness. • Austerity in periphery to lower costs and pricesDoesn' and their R • Problem: economic misery and political instability in the south 3. The Core Permanently Subsidizes the Periphery (“transfer union”) • Problem: Germans just say no • Germans don’t want to subsidize rich Southerners 4. Widespread Debt Restructurings and EZ breakup • Probably best solution … if could figure out how to do it. • Problem: Hard to predict impact? world financial meltdown?

  28. Bottom line this week • Exports and imports affect aggregate demand, particularly for very open economies. • Openness is growing in trade and finance. • Exchange rates are the monetary link among countries. • In the open economy, the tail wags the dog (tail = financial flows; dog = trade balance). • US has a chronic trade surplus because people love to put their money here (central banks and investors). • Countries face a trilemma among fixed exchange rates, domestic monetary policy, and open financial markets. • Europe has made a fateful choice in the trilemma that is devastating the continent with no end in sight.

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