Understanding the Risks and Implications of the Euro Crisis

1. Much Ado about EMU Andrew K. Rose Berkeley, Haas Andrew Rose , EMU

2. Understanding the European Crisis • What are the risks of a European Sovereign Debt Crisis? • Financial Markets: risks non-trivial but low • Currently (4/20) Greek 10-yr bond rate ≈ 13.3% • Economic and Political Fundamentals remain poor • Recession ended, but growth slow, unemployment high • Syriza elected 1/2015 to end austerity • IMF, EC, Germans seem implacable • Who’s Right? The Markets or the Fundamentals? Andrew Rose, EMU

3. How can we understand the Euro Crisis? • What are the underlying causes? • Political, Economic, and Financial • Are the policy makers and markets correct in their diagnoses? • Probably Not • What are the potential implications for Europe and the rest of the world? • Potentially disastrous Andrew Rose, EMU

4. Beware Greeks Bearing Bonds • Sovereign default was inevitable • So far voluntary; “disorderly” to come? • Current Greek 10-yr bond ≈13% (way down) • German ≈.1% (US, UK, Japan very low too) • Government Debt unsustainable (≈175% GDP) • German ≈ 75% • Big government deficits gone now • Greek “primary surplus” before interest Andrew Rose, EMU

5. How Could This Happen? • Article 103 (“No Bail-Out”) Maastricht Treaty • “… neither the Community nor any Member State is liable for or can assume the commitments of any other Member State” • But when push came to shove, spirit of Treaty violated Andrew Rose, EMU

6. Evolving E-Bailout Institutions • European Financial Stabilization Mechanism (EFSM) • EC funds (from EU budget) of €60 bn • European Financial Stability Facility (EFSF) • May 2010: to “safeguard financial stability in Europe” • Can issue €440 bn of bonds, guaranteed by members, to lend to members “in difficulty” who request help, s.t. EC, ECB, IMF (“troika”) conditionality • Greece requested and received rescue package from EU/IMF (€110 bn), May 2010 • Ireland and Portugal followed • EuropeanStability Mechanism (ESM) • Permanent bailout kitty aka “Firewall” • Increased in late March 2012 to €500m, started 7/2012, fully ready by 2014 (!) • Probably still too small (German objections; France + others wanted €1 tn) • EFSF + ESM limit is €700 bn • Draghi, Sept 2012: ESM approval implies unlimited ECB support, will do “what it takes” • European Monetary Fund (EMF) started July 2012 • Banking Union (ECB at center) started Nov 2014 – single supervisor Andrew Rose, EMU

7. How Did We Get Here? • Important to Understand Membership Requirements for EMU • Five “Convergence Criteria” required for entry • To be applied by the “Council of Ministers” • Mostly Economic, but Highly Politicized Andrew Rose, EMU

8. Convergence Criteria, 1 Institutions • Central bank independence • Easy! Andrew Rose, EMU

9. Convergence Criteria, 2 Inflation • CPI inflation within 1.5% of target • Target is average inflation of three countries with lowest inflation • Still easy! Andrew Rose, EMU

10. Convergence Criteria, 3 Interest Rates • Average long-term interest rates within 2% of target; • Target is average long-term interest rate of the three low-inflation countries • Note: some “wiggle-room” for sovereign risk premia • Again, easy! Andrew Rose, EMU

11. Convergence Criteria, 4 Exchange Rates • Fixed Exchange Rates within “normal bounds” (15%!) • No realignment within last two years • Once more: easy! Andrew Rose, EMU

12. Convergence Criteria, 5 Fiscal Positions • Members must have “Sustainable Government Financial Position”defined as: • Flow: Deficit/GDP ratio of less than 3%, and • Stock: Debt/GDP ratio of less than 60% • “Escape clauses” exist for “temporary circumstances” or declining debt • Not so easy! • Most scraped in • Greece lied its way in Andrew Rose, EMU

13. Stability (and Growth) Pact • EMU “Ins” should maintain deficits of less than 3% GDP while in EMU or face penalties • German origins • Implies pro-cyclic fiscal policy (!) • Widely flouted by large countries in practice • France ‘03-’07, Germany ‘03-’06, Italy ‘03-? • Also breaches by Greece, Netherlands, Portugal • Reformed slightly in 2005 • Revived at summit in December 2011, via “Six Pack” (2011) and surveillance in “Two Pack” (2012) Andrew Rose, EMU

14. Hence More Fiscal Austerity • Considerable pressure on Greece to maintain/raise taxes, cut spending (after 5-yr recession!) • Portugal, Spain, Ireland too • German View: Roasting the Meat (or Burning it?) • But … will this work? • The markets aren’t panicked • Most commentators agree with markets • Right way to approach the problem? Andrew Rose, EMU

15. How Should One Think about EMU? • Economists (and Haas MBA students) usually ask two questions on EMU • “Do European Countries look like an ‘Optimum Currency Area’?” • “Are European Countries similar to American Regions?” Andrew Rose, EMU

16. “Optimum Currency Areas” • Mundell’s Nobel Idea: When are two regions more likely to gain from common currency? • If they share deep trade links and • Single currency reduces transaction costs of trade • If they have similar business cycles • Same monetary policy appropriate Andrew Rose, EMU

17. But if Two Regions have AsymmetricBusiness Cycles … • Need to be able to Adjust to “Asymmetric Shocks” (good for one region, bad for another) • Otherwise boom in one region causes inflation • Recession in other causes unemployment • Costs of asymmetric business cycles can swamp (any) trade gains Andrew Rose, EMU

18. One Way to Adjust(to Asymmetric Business Cycles) • Sharing risks • System of taxes/transfers • “Robin Hood” taxes rich, transfers to needy • Relieves unemployment, inflation • In principle, can do via private sector (international cross-holdings of assets) Andrew Rose, EMU

19. An Alternative Adjustment Method • Factor Mobility • Unemployed workers move to places of high demand • Relieves unemployment and inflation Andrew Rose, EMU

20. Mundell’s “Optimum Currency Area” • Suppose business cycles are asymmetric, and • There is a) little risk-sharing, and b) immobile labor, then • Gain from using differential monetary policy to smooth different shocks • Use different monies to adjust to different business cycles • Evidence within countries (e.g., American regions) • Evidence across countries (e.g., EMU) Andrew Rose, EMU

21. Fiscal Austerity is not the Solution • It solves a different problem • Greek problem is poor competitiveness • Manifestations: current account deficit, slow growth, unemployment • Also true of other “Club Med” (Portugal …) • Classic example of “asymmetric shock” Andrew Rose, EMU

22. Competitiveness within EMU Andrew Rose, EMU

23. Bottom Line • Greece has a fiscal problem • But solving it (if possible) won’t restore growth • Difficult to sustaining pro-cyclic fiscal policy • Real problem: poor competitiveness limits growth, employment (Portugal, Spain too!) • Bubble overhangs also • No easy solution for that • Hence … more serious crisis inevitable • Could easily be worse than Lehman Andrew Rose, EMU