The euro crisis: ways out for the euro zone and its member states

1. The euro crisis: ways out for the euro zone and its member states Vesa Vihriälä 28 November 2012

2. Contents • Where do we stand? • Why is the euro crisis so stubborn? • Way(s) out • Three crises: a comparison

3. The phases of the crisis and policy reactions 2013 ??? 2012…crisis 2011Euro areaconfidence… 2010Sovereigndebt crisis 2009Greatrecession 2008Systemiccrisis 2007Sub-primecrisis Fiscal policy Stimulus Consolidation, structural reforms Monetary policy Liquidityprovision Cutting policy rates SMP LTRO OMT Bank support Recapitalization and guarantee schemes Financialassistance Bilateral Greek loansEFSM, EFSF ESM Financialmarkets Regulatory andsupervision reforms Banking union? European semester, Six-pack, Two-pack, Fiscal compact Policycoordination

4. Where do we stand now? • Eurozone is in a double dip recession • Increasing divergence among the MS • Adjustment has started but mostly slow • Also growth potential has been affected • ECB’s OMT promise has eased pressures • But the short-term outlook remains weak, and the crisis still unresolved

5. Great divergence in the euro zone GDP at 2005 market prices Unemployment rate, % Source: EU Commission projection, autumn 2012

6. Great divergence: Baltic recovery vs. Greek stagnation (at best) GDP at 2005 market prices Unemployment rate, % Source: EU Commission projection, autumn 2012

7. Competitiveness has started to improve

8. Strong variations of competitiveness in the Baltics

9. Current accounts adjust, but slowly

10. Significant fiscal consolidation

11. …which shows up in a gradual reduction of the headline deficits

12. …, including in the Baltics

13. Why is the crisis so stubborn? • The recessions associated with a financial crisis always deep and protracted • Eurozone suffers from a coordination failure • No automatic stabilisation across MS • No automatic backing of sovereign debt by the central bank • A vicious circle between banking problems and sovereign debt problems at the MS level • Decision making on financial assistance difficult among 17 sovereign nations

14. Debt levels high, but not exceptional in the euro area on average Sources: Bank of Finland, EKP, Eurostat, OECD, FED, BEA.

15. Non-solutions • Massive fiscal easing across the board • Several MS have too tight borrowing constraints • Transforming the euro zone into a genuine federal construct • Not enough political cohesion; would require a Treaty change, which time consuming and uncertain • Dissolution of the euro zone • Potentially catastrophic macroeconomic consequences, would wreck the European project

16. Way(s) out • Strengthening the current policies • Bigger, more flexible ESM • Expanded ECB action (OMT; QE) • Ambitious reforms and fiscal consolidation in the problem countries, slowing down consolidation in fiscally stronger MS • Most realistic • A banking union • Euro level supervision • Euro level deposit insurance and resolution mechanism • Very likely too slow to impact on the current crisis • A broader fiscal union, yet short of a federal state • Eurobonds, significant euro area budget • More centralised fiscal policy making • Not likely (a last resort response if dissolution threat imminent) • Debt restructurings: Greece for sure, others = ?

17. Light at the end of the tunnel? • In the best case financial conditions could improve by early 2013, following by a gradual real recovery starting by mid-2013 • Even then, growth will be slow and uneven across MS • Experience => major set backs cannot be excluded • But: EU has proved to be rather resilient in crises

18. A comparison of three crises • Finland 91-94 • Greece 2009 - • Latvia 2008 -

19. Finland in the early 1990s • Credit boom/bust as in Spain and Ireland • Key policy measures • Improved price competitiveness through depreciation and wage moderation • Relatively strong fiscal consolidation, despite a low debt level • Growth-enhancing tax reform • Strong restructuring of the banking sector • Emphasis on education and R&D; Nokia • EU membership • Relatively rapid recovery (GDP), improvement of public finances, slow but steady improvement of employment

20. Greece • Significant convergence towards EA average based on domestic demand • Badly-run public sector, high public debt • Small export sector, weak competitiveness • Adjustment has centred on fiscal consolidation, which largely self-defeating given the high debt level and slow adjustment of competitiveness • Difficult to see a sustained recovery without a further debt restructuring (PSI and OSI)

21. Latvia • A strong credit-financed domestic demand boom prior to the global crisis; a very high CA deficit • Strong fiscal consolidation and low debt level helped in regaining market confidence in the exchange rate and public finances • Wage flexibility improved competitiveness quite fast despite the exchange rate regime • Political resistance to adjustment policies moderate compared to Greece, despite (because of?) substantially lower GDP/capita level • GDP, CA recovery rapid

22. GDP adjustment fastest in Latvia GDP index: Finland (1990/Q1=100), Greece (2008/Q1=100), Latvia (2008/Q1=100) Finland: 1998Q1 89Q1 90Q1 91Q1 92Q1 93Q1 94Q1 95Q1 96Q1 Greece,Latvia: 2006Q1 07Q1 08Q1 09Q1 10Q1 11Q1 12Q1 Source: Eurostat.

23. Also the UNR adjustment fastest in Latvia Unemployment rate, %: Finland, Greece, Latvia Finland: 1998Q1 89Q1 90Q1 91Q1 92Q1 93Q1 94Q1 95Q1 96Q1 Greece,Latvia: 2006Q1 07Q1 08Q1 09Q1 10Q1 11Q1 12Q1 Source: Eurostat.

24. Depreciation helpful for restoring competitiveness but not necessary Relative unit labour costs (total economy), index Finland (1990/Q1=100), Greece (2008/Q1=100), Latvia (2008/Q1=100) Finland: 1998Q1 89Q1 90Q1 91Q1 92Q1 93Q1 94Q1 95Q1 96Q1 2006Q1 07Q1 08Q1 09Q1 10Q1 11Q1 12Q1 Greece,Latvia: Source: Eurostat.

25. CA improves slowly, except in Latvia Current account, % of GDP: Finland, Greece, Latvia Finland: 1998Q1 89Q1 90Q1 91Q1 92Q1 93Q1 94Q1 95Q1 96Q1 Greece,Latvia: 2006Q1 07Q1 08Q1 09Q1 10Q1 11Q1 12Q1 Source: Eurostat.

26. Finland slowest to reduce public deficit, thanks to the low level of debt at the outset General government deficit, % of GDP: Finland, Greece, Latvia Finland: 1988 89 90 91 92 93 94 95 96 Greece,Latvia: 2006 07 08 09 10 11 12* 13* 14* Source: Eurostat. * = EU Commission forecast.

27. Debt dynamics works against Greece General government debt, % of GDP: Finland, Greece, Latvia Finland: 1988 89 90 91 92 93 94 95 96 Greece,Latvia: 2006 07 08 09 10 11 12* 13* 14* Source: Eurostat. * = EU Commission forecast.

28. Greece relatively rich at start of the crisis GDP per capita, PPP (constant 2005 international USD) Finland, Greece, Latvia Finland: 1988 89 90 91 92 93 94 95 96 Greece,Latvia: 2006 07 08 09 10 11 12* 13* 14* Source: Eurostat. * = EU Commission forecast.

29. Some lessons • Low public debt an essential cushion to limit market reactions to deficits and to allow time for policies to work • Significant adjustment of competitiveness possible even without exchange rate changes, but requires very flexible labour markets and social acceptance of harsh policies • Sustained recovery requires also healthy real competitiveness; while the benefits of policies to this effect take time to materialize, also positive confidence effects possible => important not to delay action. • A diversified supply of financial services probably better than relying purely on domestic institutions or purely on foreign institutions.

30. Thank you!