The Euro Crisis & Greece: Six Mistakes Jeffrey Frankel Harpel Professor

1. The Euro Crisis & Greece: Six MistakesJeffrey FrankelHarpel Professor “Whither Europe? Lessons, Risks, and the Way Forward,”lecture seriesCenter for International Development, Center for European Studies, and the Kokkalis Program on Southeastern & East-Central EuropeHarvard University, Feb.13, 2012 

2. 6 mistakes made by euroland’s leaders regarding Greece • Slender rays of hope: • The hour of the technocrats • Proposals for the future

3. 5 mistakes made by euro leaders • Admitting Greece to the € in the first place, • a country that was not yet ready. • Pretending to enforce the fiscal criteria: • BD < 3% of GDP & Debt < 60% of GDP. • Allowing Mediterranean countries’ bonds spreads near 0 • helped by investors’ under-perception of risk (2003-07) • and artificial high credit ratings. But also • ECB acceptance of Greek bonds as collateral. When the crisis hit, the leaders buried their heads in the sand: • 2 years ago, sending Greece to the IMF was “unthinkable.” • 1 year ago, restructuring of the debt was “unthinkable.”

4. The Treaty of Maastricht (1991) surprised many economists by emphasizing fiscal criteria as qualifications for membership. Why did the designers do it? • Theory I: Jason & the Golden Fleece • Theory II: Theseus& the stone • Theory III: Odysseus & the mast. Frankel, Economic Policy (London) 16, April 1993, 92-97.

5. The motivation fortheMaastrichtfiscalcriteria • was the same as for the No Bailout Clause • and the Stability & Growth Pact (1997): • Skeptical German taxpayers believed that, before the € was done, they would be asked to bail out profligate Mediterranean countries. • European elites adopted the fiscal rules to demonstrate that these fears were groundless.

6. After the euro came into existence • it became clear the German taxpayers had been right • and the European elites were wrong. • E.g., Greece persistently violated the 3% deficit rule. • The large countries violated the rule too. • SGP targets were “met” by overly optimistic forecasts. • SGP threats of penalty had zero credibility. • Yet each year the ostrich elites stuck their heads deeper & deeper into the sands.

7. The Greek budget deficitnever got below the 3% of GDP limit,nor did the debt ever decline toward the 60% limit

8. Spreads for Italy, Greece, & other Mediterranean members of € were near zero, from 2001 until 2008. Market Nighshift Nov. 16, 2011

9. When PASOK leader George Papandreou became PM in Oct. 2009, • he announced • that “foul play” had misstated the fiscal statistics under the previous government: • the 2009 budget deficit ≠ 3.7%, as previously claimed, but > 12.7 % !

10. Missed opportunity • The EMU elites had to know that someday a member country would face a debt crisis. • In early 2010 they should have viewed Greece as a good opportunity to set a precedent for moral hazard: • The fault egregiously lay with Greece itself. • Unlike Ireland or Spain, which had done much right. • It is small enough that the damage from debt restructuring could have been contained at that time. • Unlike Italy now, if the worst happens. • They should have applied the familiar IMF formula: serious bailout, but only conditional on serious policyreforms & serious PrivateSectorInvolvement.

11. But the ostriches stuck their heads ever further down in the sand. • There is even less reason now to think Brussels can impose fiscal constraints on borrowers or ask unlimited transfers from creditor country taxpayers than before.

12. Slender rays of hope, #1 • Greece, Ireland & Portugal did finally go to the IMF; Germany & banks did finally agree to write down Greek debt. • But it has always been much too little, too late. • The only solution for the short-term: • a lot more money • from ECB & • national governments, • conditional on reforms + PSI, country-by-country.

13. Slender rays of hope, #2: The Hour of the Technocrats • A government of technocrats under Mario Monti in Italy is a huge improvement over the disaster of Berlusconi. • Similarly Lucas Papademos in Greece • But he has been given even less freedom of action than Monti: his term is very short and he wasn’t allowed to pick his cabinet.

14. Mario Draghi became President of the ECB, Nov.1, 2011 • He was under intense pressure to expand his predecessor’s purchases of large quantities of periphery-country bonds. • The ECB was urged to be the “big bazooka”: • to play the role of “lender of last resort,”an abuse of that term, • which is supposed to refer to back-stopping banks, not countries. • If the ECB interpreted its mandate literally, as no more than keeping inflation low, then the euro might break up. • On the other hand, as Draghi knew: • the ECB is legally prohibited from financing governments directly; • If he had quickly bailed out Italy & the others, he would have: • facilitated a continuation of Berlusconi-style irresponsibility; • been immediately written off by Germans as another profligate Italian.

15. So far, Draghi’s LTRO (Longer-Term Refinancing Operation) has been a brilliant success. • On Dec. 22, he caught everyone by surprise by the clever ploy of doing exactly what he had previously announced he would do: • loans to banks for 3 years, at low interest. • High take-up: €489b, 523 banks • especially in troubled countries. • No stigma. • Brought down interbank spreads & country spreads, • while consistent with central bank LoLR mandate. • 2nd round in late February may be twice as big.

16. Any solution to the euro crisis must include a way to prevent repeats in the long term. • As the Maastricht architects knew all along, this means a way of preventing fiscal moral hazard: • preventing individual countries from running big deficits & debts, expecting to be bailed out in the event of a crisis. • The German taxpayers are no more supportive of a “transfer union” than ever. • Merkel’s “fiscal compact” is the 6th mistake: • yet another declaration of determination to strengthen the SGP, • incl., via budget limits in national laws/constitutions. • One SR problem: Europeans think austerity is expansionary

17. Perhaps the Fiscal Compact misunderstands the US system • Yes, despite a common currency, the 50 states do not seem to have moral hazard: • the federalgovernment has never bailed one out, • and nobody expects it to now. • But that is not because of the budget rules that (49 of) the states have. • Their rules are voluntary, varied, and flexible. • Some states do have debt troubles, • and even default.

18. How the US avoids moral hazardin the 50 states • Government spending at the state level is a far smaller share of income than at the federal level, • let alone on the part of European states. • Is Europe ready for that? No. • When one state begins to run its debt too high, the private market automatically imposes an interest rate penalty. • E.g., California today. • Gives states the incentives to get back in line. • This mechanism was expected to operate in euroland • Alesina, et al (EP, 1992) and Goldstein & Woglom (1992). • but conspicuously failed from the first day. • Which showed that moral hazard had not been addressed.

19. EMU Ostrich

20. References by the speaker • “The ECB’s Three Big Mistakes,” VoxEU, May 16, 2011. • “Optimal Currency Areas & Governance", slides session on the Challenge of Europe at the Annual Conference of George Soros’ INET, April 2011; video available, including my presentation. • "Let Greece Go to the IMF," Jeff Frankel’s blog, Feb.11, 2010. • Over-optimism in Forecasts by Official Budget Agencies and Its Implications," 2011, forthcoming in Oxford Review of Economic Policy. • “A Solution to Fiscal Procyclicality:  The Structural Budget Institutions Pioneered by Chile,” Fiscal Policy and Macroeconomic Performance,  Central Bank of Chile, 2011.  NBER WP 16945, April 2011. • “The Estimated Effects of the Euro on Trade:  Why are They Below Historical Evidence on Effects of Monetary Unions Among Smaller Countries?” in Europe and the Euro, Alberto Alesina & Francesco Giavazzi, eds. (U.Chic.Press), 2010.    • "Comments on 'The euro: It can’t happen, It’s a bad idea, It won’t last. U.S. economists on the EMU, 1989-2002,' by L.Jonung & E.Drea," slides. Euro at 10: Reflections on American Views, ASSA meetings, San Francisco, 2009. • "The UK Decision re EMU: Implications of Currency Blocs for Trade and Business Cycle Correlations," in Submissions on EMU from Leading Academics (H.M. Treasury: London), 2003. • "The Endogeneity of the Optimum Currency Area Criterion" (with Andrew Rose), The Economic Journal, 108, no.449, July 1998. • “‘Excessive Deficits’: Sense and Nonsense in the Treaty of Maastricht; Comments on Buiter, Corsetti and Roubini,” Economic Policy, Vol.16, 1993.

21. Appendix A: Interest rate penalties on the bonds of overly indebted US states

22. Spreads help keep profligate US states in line= reason why no state has ever been bailed out by the Federal government, despite some defaults. Yield tomaturity in % 22 Source: W.B. English, „Understanding the costs of sovereign default …,“ p. 269. as used by Holtfrerich (2011)

23. California Municipal Bonds(now the lowest rated of the 50- states)Credit Default Swapshttp://blogs.reuters.com/muniland/2011/06/08/muni-sweeps-lockyer-rides-again/

24. Appendix B: Proposals for the future #1 Emulate Chile’s successful fiscal institutions • Phrase budget targets in structural terms, which is also the Swiss rule. b) Give responsibility for determining what is structural to an independent professional agency, to avoid forecast bias.(Frankel, 2011)

25. Even Greece’s primary budget deficithas been far in excess of 3% since 2008 Source: IMF, 2011.I. Diwan, PED401, Oct. 2011

26. Even though in most years true Greek budget deficitswere far in excess of the supposed limit (3% of GDP). the official budget forecasts were always rosy. Until, in 2009, the bottom fell out of the budget. Source: Frankel & Schreger (2011)

27. Proposals for the future: #2 Penaltywhen a euro country misses its target: • The ECB then stops accepting new bonds as collateral. • => Sovereign spread rises, with automaticity. • Proposal from Brueghel(JvW & ZD): All of euroland is liable for blue bonds (issued up to SGP limits); Issuing country is liable for red bonds (beyond those limits) . • Blue bonds share advantages with other eurobond proposals: • ● ECB can conduct monetary policy. • ● They could offer an alternative to US TBillsfor PBoC & other desperate global investors

28. Blue bonds & red bonds Gavyn Davies, FT Source: