The Eurozone Crisis? Will the Euro Survive?

1. The Eurozone Crisis? Will the Euro Survive? Michael Bordo Rutgers University, Hoover Institution and NBER

2. Introduction • EMU and ECB were a culmination of a long process of economic integration going back to the end of WWII • The negotiations leading to EMU began in the 1970s after the breakdown of the BWS • Opposition to floating exchange rates and fear of US international monetary dominance drove the project forward

3. Introduction • The Great Inflation and weak dollar of the 1970s and strong dollar in the 1980s put considerable stress on the weaker European currencies relative to the DM • This led to instability in the “snake in the tunnel” and the EMS • This contributed to the case for perfectly rigid exchange rates combined with a DBB style ECB to provide sound money

4. Introduction • EMU went forward despite skepticism that it did not satisfy the OCA criteria of labor mobility and a fiscal union • Maastricht 1992 left out a fiscal union despite misgivings by key players • Proponents argued that financial integration would lead to private insurance mechanisms as a substitute for a fiscal union • They also expected labor market reform • The Maastricht ‘no bail out’ clause and the SGP fiscal limits would make up for the absence of a fiscal union • Finally Maastricht did not include a banking union

5. From Early Success to Crisis • Bordo and Jonung (2003) distinguished between national and international MUS • National MUs predicated on political unification and fiscal union were more successful than international MUs • The key determinant of success was the common belief by the founding member states in the creation of an overarching national (federal ) state

6. From Early Success to Crisis • We argued that EMU seemed closer to a national than an international MU • But its success would ultimately depend on political will • The question arises over a decade later: • How has the EMU fared? And will it survive going forward?

7. From Early Success to Crisis • For its first 8 years the EZ seemed to be thriving without a fiscal union or a banking union • There was significant integration in goods and capital markets but labor mobility languished • The integration of capital markets led to the convergence of sovereign bond yields across the EZ • See figure 1

8. Figure 1. Bond Yields in the Eurozone

9. From Early Success to Crisis • Many argued that this reflected successful integration • Others believed that convergence reflected a cynical belief that the ‘no bail out’ clause would not hold in the event of a debt crisis in a peripheral country

10. From Early Success to Crisis • The 2007-2008 subprime mortgage crisis created the conditions for the existential shock that the euro skeptics prophesied • The crisis and Great Recession led to large fiscal deficits and run ups in national debt as member states increased G to offset recession and tax receipts declined

11. From Early Success to Crisis • The incidence of the crisis/recession fell more on the peripheral countries which had slower growth and were less competitive. • The fiscal imbalances were in part tempered by the operation of TARGET 2, which accommodated the member NCBs demands for liquidity • See figure 2

12. Figure 2. Net claims of the NCBs resulting from transactions within the Eurosystem

13. From Early Success to Crisis • Matters took a turn for the worse in 2010 when it was revealed that Greece’s fiscal position was much more dire than originally believed • The Greek debt crisis and the initial reluctance by the EZ not to bail out Greece led to a wide divergence in sovereign spreads seen in figure 1 • It also led to contagion to other peripheral countries that had weak fundamentals • Banks in the fiscally challenged countries were exposed because of their large holdings of domestic sovereign debt • Banks in other advanced EZ countries were also exposed to peripheral sovereign debt

14. From Early Success to Crisis • The EZ authorities were initially opposed to a Greek restructuring for fear that it would force Greece to leave the EZ • Greece was forced into painful fiscal consolidation and contraction • In 2011 when it became clear that Greek fundamentals were unsustainable the Troika worked out a restructuring

15. From Early Success to Crisis • This action exposed the IMF to credit risk and violated principles established after the 1990s EM crisis • Had the EZ authorities and IMF initially treated the Greek crisis like an EM crisis and restructured the debt when the crisis broke out the deterioration in debt markets that followed could have been avoided • The Greek rescue and others for Portugal and Ireland reduced sovereign spreads somewhat but did not end the crisis

16. From Early Success to Crisis • The 2010-2012 EZ debt crisis more than the 2007-2008 global financial crisis revealed the fundamental mistakes of omitting fiscal and banking unions from the original deal • Had they been in place, much of the fiscal, financial and real dislocation could have been avoided • A euro bond like Alexander Hamilton’s 1790 national bond and a euro wide resolution mechanism like FDIC would have made a big difference

17. From Early Success to Crisis • Had the peripheral EZ countries been on floating exchange rates they could have avoided most of the deflation and adjustment would have been faster eg Iceland • In the absence of a fiscal union the ECB was pressed into service to resolve the crisis • In Spring 2010 Trichet pledged to support peripheral sovereign debt markets • In July 2012 OMT promised unlimited liquidity support for the sovereign debt markets of the EZ

18. From Early Success to Crisis • OMT was successful in reducing sovereign debt spreads • OMT was sold as a liquidity/LLR policy to be consistent with the ECBs mandate • In actual fact the jump in spreads between 2010-2012 reflected the deep seated structural flaws behind the fiscal imbalances • They reflected insolvency rather than illiquidity • The ECB has been engaging in fiscal policy which violates both its independence and its mandate

19. Conclusion: Will the Euro survive? • The EZ crisis has been (temporarily) allayed by ECB actions • The deeper real problems of slow labor mobility, divergent productivity and competitive trends, excessive regulation and slow economic growth are still there • There has been limited progress towards a banking union but no progress towards a fiscal union • It has been opposed by member states fearing losing sovereignty

20. Conclusion: Will the Euro survive? • The collapse of the EZ has been avoided by the exertion of political will • This has compromised the independence of the ECB • As long as political will for EMU prevails (regardless of the costs to the EUs fundamental institutions) the EZ will limp forward • Unless the flaws of EMU are really corrected the prospects for a crisis free future are limited