ISS Public Lecture Six Lessons from the Euro Crisis f or Completing the European Project

1. ISS Public Lecture • Six Lessons from the Euro Crisis • for Completing the European Project • The creation of the European Union has proceeded in stages, interrupted by external and internal events. Each setback has led to a change in the approach adopted by the Member States. The interruption caused by the current crisis is no exception. But, it may represent a crucial turning point if the lessons of the crisis are not interpreted appropriately.  In particular the current crisis provides lessons about the difficulties involved in dealing with economic imbalances, whether at the regional or the global level.  The experience of the Eurozone in providing asymmetric regional convergence of economies with different backgrounds and performance thus has implications not only for international reform proposals, but also for the kind of International Financial System that would provide support for developing countries. • Jan Kregel, • Levy Economics Institute

2. Six Lessons From the EUro Crisis • Every crisis reveals unexpected consequences of economic policies. The current Euro crisis should be no exception. As EU governments grapple with the crisis, there are already a number of lessons to be learned. • 1. Currency zones don’t solve the problem of International (or Regional) payments imbalances. • 2. The “structuralists” got it wrong, the “economists” got it right • 3. There is no French-German Compromise on Policy Convergence • 4. Increased Competition reduces inflation, but does not guarantee Growth Convergence • 5. A Common Currency does not eliminate the need for internal adjustments • 6. The Problem is not the lack of full European Political Union or an EU Fiscal Authority to Complement the ECB • What is the Problem? For Greece -- For the Euro zone

3. 1. Currency zones don’t solve the problem of International (or Regional) payments imbalances. • The problems that are now being faced are not new: Remember the global imbalances and currency turbulence that produced the 1985 Plaza Accord and then the meeting at the Louvre and finally the free-fall collapse of the dollar? • At that time many economists proposed that the exchange rate instability produced by the global payments imbalances could be resolved by dividing the world into unified dollar, DM and Yen currency zones. • However, the introduction of the Euro as an ersatz DM zone does not seem to have produced the stability that the proponents of such a system had envisaged, even within the Euro zone. • Indeed, the attempts to manage the dollar-DM-Yen exchange rates in the Plaza and Louvre Agreements eventually generated an equity and real estate bubble in Japan whose collapse ushered in decades of stagnation and eliminated any possibility for the creation of a Yen zone in Asia.

4. 2. The “structuralists” got it wrong, the “economists” got it right • Recall the debates between the “economists” and “structuralists” on the appropriate means of transforming the European Economic Community into a unified economic zone. • The structuralists argued that it was important to create common structures and that eventually the member economies would conform to them. This was a justification for the Common Agricultural Policy, which created de facto fixed rates to distribute EU support. The same argument was used in justification of the introduction of a common currency despite wide disparity in economic performance in the EU. • The “economists” on the other hand argued that common structures could only emerge from a long process of economic convergence; the introduction of the common currency should be the crowning achievement of European integration. It is impossible to know if this would ever have been achieved, but it is quite clear that the expectations of the structuralist approach have been disappointed.

5. 3. There is no French-German Compromise on Policy Convergence • Third, remember the old Exchange Rate Mechanism (ERM)? It was designed to remedy the difficulties caused by the speculative capital flows produced by the persistent policy and growth and inflation performance differences between the major European countries. The flows were usually into the DM, causing appreciation and difficulty in domestic monetary policy. • The final structure of the ERM was a compromise between two objectives. France in particular sought to soften the constraining impact that low inflation in Germany and real DM appreciation had on domestic activity. Germany on the other hand sought to use the mechanism to encourage convergence to German monetary and fiscal policies. This was to be resolved by the introduction of a reference currency unit, the ECU, with relative large fluctuation bands against national currencies. • However, the ERM was constructed as a bilateral exchange rate grid, substantially reducing much of the hoped for range of flexibility. Here the economists scored a clear advantage.

6. 4. Increased Competition reduces inflation, but does not guarantee Growth Convergence • Recall the Single Market Act (SMA) and Economic and Monetary Union (EMU) to be introduced in 1992? This was basically an attempt to respond to the disappointing growth rates and slow pace of convergence by means of supply side policies to create a fully integrated internal market for goods and services. • The 1988 Cecchini Report claimed that Community income could be increased by at least 5% as a result of these structural changes to open borders and increase competition within the Community. This clearly did not happen as EU average growth rates have continued to decline from 3.2% during the dismal 1970s, to 2.25% in the 1980s to and below 2% in the 1990s. • However, it did produce a decline in inflation rates from over 10 % in the 1970-80s to below 2% in the 1990s. Paradoxically, the policies only served to compress demand and produce the nominal convergence of economic variables required to proceed to monetary union.

7. 5. A Common Currency does not eliminate the need for internal adjustments • Fifth, the introduction of monetary union, in the form of a common currency, was to be the logical complement of the SMA to ensure that exchange rate changes did not distort relative competitiveness in the internal market. However, policy and performance divergences have continued to exist, and German policy to reduce efficiency wages as part of its adjustment to the debts built up by German reunification, in the presence of higher rates of productivity, have recreated the same problems of divergent competitiveness as those caused by the pre-ERM exchange rate misalignments. • Without the expedient of exchange rate adjustments other member states were faced with the prospect of forcing reductions in their domestic wage levels and domestic purchasing power or using fiscal policies to offset the losses of sales to domestic producers and keep growth and employment expanding despite the continuing losses in relative productivity and competitiveness. • In addition, common interest rate policies, which for many countries were too low for domestic conditions exacerbated these problems. The result was growing differences in government debt, and growth and tax yields which are now producing the sovereign debt crisis which is threatening the survival of the Euro. This is, of course, just the mirror image of the position of the economists noted in lesson 2.

8. 6. The Problem is not the lack of full European Political Union or an EU Fiscal Authority to Complement the ECB • Among the proposals to respond to the current crisis: • common fiscal policy, • EU supranational Treasury • debt instrument issued by the European Commission • Larger Share of Commission Expenditure relative to EU GDP • These proposals are not concerned with financing of expenditures of the Commission, but simply with the creditworthiness of the sovereign debts accumulated by the individual member states. The argument is that the problem of the creditworthiness of European government debt would be solved if there were a more complete political union: EMPU!

9. EURO Eliminates Zero Risk Assets in EU • The creation of the European Central Bank as the issuer of the common EU currency meant that the zero-risk sovereign debts of Euro zone governments where no longer fully sovereign in the sense that they could always be redeemed by the issue of additional debt or national currency. With the advent of the Euro, the debt of national governments became the equivalent of private debt. • The ability to repay the debt, or even to meet the debt service, depended on the ability of the government to generate a fiscal surplus. In the absence of the ability to borrow from the ECB, the creditworthiness, or sustainability, of government debt, depends on a fiscal surplus at least sufficient to meet debt service.

10. INTEREST RATE CONVERGENCE • On entry into the Euro a high debt economy such as Italy should have had a fiscal surplus higher than a low debt country to achieve an equivalent credit rating. However, the common interest rate set by the ECB, and the failure of financial markets to price government debt according to sustainability meant that highly indebted countries saw their debt service decline, and thus reduce the necessity to run higher surpluses. Indeed, pre-Euro introduction market speculation to profit from the capital gains on high coupon debt that was expected to occur with interest rate convergence produced that result. • Markets thus ignored the large difference in outstanding debt ratios across countries and accepted that the uniform debt and deficit conditions set in the Stability and Growth Pact would be honoured. But this eventuality would have meant a certain path to divergence, not to convergence, of debt ratios and economic performance.

11. Risk-Adjusted Interest Rates?

12. Differential Impact oF Capital Flows • Differential Impact of Capital Flows: • “Northern” economies attracted investments in “productive” sector • “Southern” economies attracted investment in real estate • positive relationship between FDI and trade balances for “North” • negative relationship for the “South” Accentuated Divergence After Introduction of the Euro: • After 1999 substantial rise in the net inflow of FDI in the euro area. • At industry level: • positive relationship between FDI in manufacturing sector and the trade balance in the North • negative relationship between FDI in non-manufacturing sector and trade balance for South • When FDI inflows are channeled to the productive/tradable (unproductive/non-tradable) sector, this leads to substantial improvement (deterioration) in productivity and competitiveness in the long run.

13. Hedge or PONZI FINANCE • For EZ government debt to be risk free, it has to guarantee that it will be able to meet the debt service out of current revenues. Since the government cannot create Euros, but only generate them by taxing the private sector, this means that it must run a fiscal surplus sufficient to cover current interest as well as paying down debt to reach the SGP limits. • In Minsky’s terms it must be engaged in hedge finance. In the absence of a fiscal surplus the government must issue additional debt to the private sector since it is formally forbidden to borrow from the ECB. In this case the government is engaging in what Minsky called “Ponzi” finance. • The concern of the ECB to introduce ironclad conditions on fiscal deficits is understandable if it is to respect the prohibition on lending directly to governments. However, such a policy is also unsustainable, as has been more than evident in the current crisis.

14. Respecting Financial Balances • If all governments run hedge profiles, then whatever the maximum debt ratio chosen, the surplus as a share of GDP cannot fall short of the interest rate paid on the debt. The ECB’s control of interest rates thus also indirectly controls fiscal policy and increases its leverage on the level of economic activity. No common security or EU Treasury is necessary to achieve this result. Indeed, a common Treasury or issue of a common bond in the absence of the ability of the ECB to lend to it would simply create a surplus on the aggregate level capable of meeting the debt service on the common debt. • But this route to stability of sovereign debt does have an impact on the structure of financial balance sheets. If the government is running a fiscal surplus, then the balance of the private sector deficit and the external surplus must be sufficient to offset it, otherwise incomes will be falling. If, as is usual, the private sector and the public sector are in surplus, then the Eurozone as a whole becomes a gigantic drain on global demand simply to keep European income levels stable. Or to put it another way, debt stability depends on global levels of activity. And the Euro creates a black hole for global demand, which risks creating the kind of financial imbalances it is meant to eliminate.

15. Who Will Provide Risk Free Assets to Finance Deficits? • Of course, the problem could be resolved if the ECB were able to act as the lender of last resort to allow governments to run fiscal deficits as required to keep incomes at an acceptable rate of growth, since the sustainability of the ECB’s debt is independent of its net income. The solution to the problems of the Euro will not lie in the prickly problems of political unification or unified fiscal policy.

16. What is the Problem? • 1. For Greece • Meeting Debt Service: Budget Problem: + Receipts - Expenditures • Internal Adjustment: Competitiveness problem: Reduce wage costs • Building an Export Sector: NO ONE IS DOING THIS • 2. For the Survival of the European Union • Globally Sustainable Budget Policies • Everyone cannot run a Surplus • Unless ROW runs a Deficit • Global Imbalances have to be Permanent?

17. Is There a Solution? Reduce Debt and Deficits? 17 • The ability of the Sovereign to • Meet debt service • Requires increased Tax yields • (T>G). • This requires Private Sector to • Increase tax payments • Reduce Consumption, Increase saving • CAN THIS BE DONE Without Reducing Income?? The Debt Crisis in Greece and the Eurozone: Is there a Solution?

18. Is There a Solution? Reduce Debt and Deficits? 18 • The ability of the private sector to • repay debt • increase tax payments • Requires private sector credits • Households: Y-C > 0 • Firms: Profits > 0 • Combined Private sector: S> I The Debt Crisis in Greece and the Eurozone: Is there a Solution?

19. Minsky: How will borrower Repay? 19 • Sovereign: • 1)Hedge: • T>G • 2) Speculative: some more debt • 3) Ponzi: only more debt, asset sales • Private Sector: • 1) Hedge: • a) S>I • 2) Speculative: some more debt • 3) Ponzi: only more debt, sell assets Macro Economic Balance 0 = (S-I) + (T-G) + (X-M) The Debt Crisis in Greece and the Eurozone: Is there a Solution?

20. 0 = (S-I) + (T-G) + (X-M) 20 • Private Sector: • S-I < 0 (more debt) • ________________ • Fiscal Balance • T-G < 0 (more debt) • ________________ • External Balance: • X-M > 0 • X-M = (S-I) + (T-G) • 1 Sovereign Repay • T-G>0 • ________________ • 2 Private Sector Repay • S-I < 0 • __________________ • 3 Private & Govt Repay • S-I > 0 &T-G > 0 The Debt Crisis in Greece and the Eurozone: Is there a Solution?

21. Financial Balance: Government 21 The Debt Crisis in Greece and the Eurozone: Is there a Solution?

22. Financial Balance: Government 22 The Debt Crisis in Greece and the Eurozone: Is there a Solution?

23. Financial Balances: Private Sector balance The Debt Crisis in Greece and the Eurozone: Is there a Solution?

24. Financial Balances: Private Sector Delevers The Debt Crisis in Greece and the Eurozone: Is there a Solution?

25. Financial Balances: Private and Government Surplus The Debt Crisis in Greece and the Eurozone: Is there a Solution?

26. Feasible Range for Country to Repay Debt Stability and Growth Pact Fiscal Deficit Limit = -3% Private Sector Surplus S>I Fiscal Surplus = 0% Fiscal Surplus = 2% Fiscal Surplus = 4% +1.5% Current Account Deficit Current Account Surplus +1% +2% -1.5% -1% -2% Increasing Fiscal Surplus Private Sector Deficit S<I

27. Feasible Range with Export Constraint Stability and Growth Pact Fiscal Deficit Limit = -3% Private Sector Surplus S>I Fiscal Surplus = 0% Fiscal Surplus = 2% Fiscal Surplus = 4% +1.5% Current Account Deficit Current Account Surplus +1% +2% -1.5% -1% Increasing Fiscal Surplus -2% Private Sector Deficit S<I

28. Fiscal Surplus T>G Ib II Ib Private Sector Deficit S<I Private Sector Deficit Private Sector Surplus S>I Ia Current Account Deficit X<M Current Account Surplus X>M IIIb Private Sector Deficit Private Sector Surplus Private Sector Balance = 0 IV Private Sector Surplus IIIa Fiscal Deficit T<G II

29. Fiscal Surplus Private Sector Surplus = 0% Private Sector Surplus = 2% Private Sector Surplus = 4% Current Account Deficit Current Account Surplus +1% +2% -1% Increasing Private Sector Surplus -2% Fiscal Deficit

30. Feasible Range to Repay Debt Fiscal Surplus T>G Private Sector Deficit S<I Private Sector Deficit Private Sector Surplus S>I Current Account Deficit X<M Current Account Surplus X>M - 3% Stability and Growth Deficit Limit Private Sector Deficit Private Sector Surplus Private Sector Financial Balance = 0% Private Sector Surplus Fiscal Deficit T<G

31. Feasible Range with Export Constraint Fiscal Surplus T>G Private Sector Deficit S<I Private Sector Deficit Private Sector Surplus S>I Current Account Deficit X<M Current Account Surplus X>M Stability and Growth Deficit Limit - 3% Private Sector Deficit Private Sector Surplus Private Sector Financial Balance = 0% Private Sector Surplus Fiscal Deficit T<G

32. Probable Range for Euro Periphery Fiscal Surplus T>G Private Sector Deficit S<I Private Sector Deficit Private Sector Surplus S>I Current Account Deficit X<M Current Account Surplus X>M - 3% Stability and Growth Deficit Limit Private Sector Deficit Private Sector Surplus Private Sector Financial Balance = 0% Private Sector Surplus Fiscal Deficit T<G

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