Will the euro survive? Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times

1. Will the euro survive?Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times Nottingham University 14th February 2013

2. Will the euro survive? “The effort to bind states together may lead, instead, to a huge increase in frictions among them. If so, the event would meet the classical definition of tragedy: hubris (arrogance); até (folly); nemesis (destruction).” Martin Wolf, FT, December 1991.

3. Will the euro survive?

4. Will the euro survive? • Why did the crisis happen? • What are the results of the crisis? • Is the crisis being solved? • What does this mean for the UK?

5. 1. Why did the crisis happen? • The crisis is not, in its origin, a fiscal crisis, as many think, but a balance of payments crisis: • In the run up to the crisis, there were huge internal capital flows. These opened up current account imbalances and generated huge divergences in competitiveness. • After 2008, cross-border private financial flows suffered a series of “sudden stops”. These caused, or aggravated, fiscal crises. • The view that this is a fiscal crisis lets creditors blame debtors. • The correct view that this is a financial crisis puts blame on creditors, debtors and the system. 5

6. 1. Why did the crisis happen? NOT THE ROAD TO THE EUROZONE CRISES 6

7. 1. Why did the crisis happen? CONSEQUENCES OF THE CRISIS 7

8. 1. Why did the crisis happen? ROAD TO THE EUROZONE CRISES 8

9. 1. Why did the crisis happen? LOST COMPETITIVENESS 9

10. 1. Why did the crisis happen? • Why were proponents of the eurozone unaware of the danger of cross-border financial flows and current account imbalances? • They thought these flows were the purpose of the exercise; • They thought currency risk was the only danger; and • They thought they had eliminated currency risk. • They were wrong: • Currency risk cannot be eliminated; and • It will re-emerge as credit risk. 10

11. 1. Why did the crisis happen? • Even regions within countries can suffer the consequences of current account imbalances: • But mechanisms for handling the worst consequences of regional “busts” exist: • Support for the financial system; • Fiscal transfers; and • Labour mobility. • Eurozone member countries are in a gold-standard type of mechanism: adjustment goes via depression. 11

12. 1. Why did the crisis happen? • They did have a central bank, which has helped through a range of programmes, including recently the Long-term Refinancing Operations for banks and Outright Monetary Transactions, for sovereigns • But, as Spain has discovered, support from the European Central Bank is not the same as having one’s own central bank and a floating exchange rate. • Spain and UK have similar fiscal situations, but very different interest rates on public debt. • This reveals liquidity, credit and break-up risk. 12

13. 1. Why did the crisis happen? WHO’S THE MORE INDEBTED? 13

14. 1. Why did the crisis happen? WHO’S THE MORE INDEBTED? 14

15. 1. Why did the crisis happen? • High-income countries embedded inside a currency union are more vulnerable to balance of payments cum financial crises than countries with floating exchange rates and their own central banks. • They are like emerging countries with exceptionally hard exchange-rate pegs, though they do enjoy semi-automatic monetary financing from the ECB. • Thus the currency union has replaced the brief currency crises of the exchange-rate mechanism with long-running solvency, employment and political crises. 15

16. 2. What are the results of the crisis? • The results of the crisis have included: • Exorbitant bond yields in deficit countries; • Dwindling cross-border finance, capital flight, bank runs; • Tighter links between domestic banks and their sovereigns; • Private retrenchment, collapsing GDP and soaring unemployment; and • Rising political friction. 16

17. 2. What are the results of the crisis? FLIGHT FROM VULNERABLE COUNTRIES’ BONDS

18. 2. What are the results of the crisis? THE EROSION OF FINANCIAL INTEGRATION

19. 2. What are the results of the crisis? THE EROSION OF FINANCIAL INTEGRATION

20. 2. What are the results of the crisis? ECB INTERVENTION

21. 2. What are the results of the crisis? ECB INTERVENTION

22. 2. What are the results of the crisis? ECB INTERVENTION

23. 2. What are the results of the crisis? THE PATH TO SLUMP 23

24. 2. What are the results of the crisis? THE PATH TO SLUMP 24

25. 2. What are the results of the crisis? THE PATH TO STAGNATION 25

26. 3. Is the crisis being solved? • The euro will probably survive. But the crisis is definitely not over. • I see three scenarios – good marriage, bad marriage or (full or partial) divorce: • Divorce would be costly and hard to manage; • Bad marriage is very painful; • The aim is to reach good marriage. • But reaching that destination will take a lot of reform, both economic and political, and will take up to a decade.

27. 3. Is the crisis being solved? • Here are the challenges to be met: • Debt write-offs: to clear up the legacy costs of the poorly structured and managed currency union, Mark I. • Financing: to prevent collapses. By “financing”, I mean maintaining a working financial system and manageable costs of government funding. The ECB is now doing much of this. That is risky, but necessary. • Adjustment: structural reforms and divergent inflationacross the eurozone, with higher inflation and stronger final demand in core countries. This will take at least 5-10 years. • Long-term reform: creating a workable union that is not a full federation 27

28. 3. Is the crisis being solved? • Debt write-offs: • There has been a debt write-off for Greece. But the likelihood is that further large write-offs will be needed, particularly because the adjustment mechanism creates debt deflation, via falling nominal GDP. These write-offs may include big countries. • Financing: • There is a trade-off between financing and adjustment. The ECB’s interventions, plus the creation of the European Stability Mechanism has created adequate financing, in the short run. But political and economic developments may force activation of the OMT. Its internal contradictions – “unlimited, but conditional” – may then blow it apart. It may have worked because it has not been tested. 28

29. 3. Is the crisis being solved? • Adjustment: • Adjustment means a current account financed sustainably by private funds, with the economy at close to full potential. • There have been external adjustments, much due to deep recessions. Competitiveness needs to be restored and new industries created. • Meanwhile, fiscal adjustment in countries with large deficits inevitably leads to recession when the private sector is also retrenching. • If external adjustment is unsuccessful, external balance may mean internal imbalances – i.e. long-term slumps, with high unemployment and emigration of qualified people. • Adjustment is made more difficult by structural surpluses in core countries, particularly Germany. 29

30. 3. Is the crisis being solved? • Long-term reform: • The aim is to create what I think of as a minimum federation • This should include: • A banking union: this would be possible, without fiscal backup, if (and only if) banks could be resolved without budgetary support. • An adequate safety net: Eurobonds are one way to do this; and an even bigger European Stability Mechanism, plus European Central Bank support, is another. • Permanent transfers would be dangerous. • But it has to be an adjustment union more than a fiscal union. 30

31. 3. Is the crisis being solved? • Willingness to act proved substantial, once it became obvious that the original design had failed. But willingness to act has also been insufficient. • The force for action is the lack of an alternative. • The obstacles are of three kinds: • Economic: it is hard to make this work; • Ideological: the difference in economic perspectives are large; and • Political: the countries and peoples neither like one another nor identify with one another. Reforms also raise huge questions about political legitimacy.

32. 4. What does this mean for the UK? • What does this mean for Britain? • It means fundamental change in relations with the rest of the EU, for sure. • But the nature of the fundamental change depends on the outcome for the eurozone over which Britain has little, if any, influence. • The way I analyse this question is as follows: • The status quo in the eurozone is untenable; • Thus, the eurozone will either fragment or it will become much more integrated.

33. 4. What does this mean for the UK? • If the Eurozone integrates, the UK may find itself at its mercy of the Eurozone decision-making process. • This might tip the UK’s political balance towards exit. • The future of the EU, and so of the UK in the EU, has become extremely unpredictable. • The likely need for a treaty ratification may trigger the upheaval.