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

Beware Greeks Bearing Bonds Sovereign default was inevitable So far voluntary; “disorderly” to come? Current Greek 10-yr bond >30% German ≈2% (US, UK, Japan too) Government Debt unsustainable (≈150% GDP) German ≈ 80% Big government deficits (≈10% GDP) imply continuing deterioration German ≈ 1% Andrew Rose, EMU

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

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 European Stability Mechanism (ESM) Permanent bailout kitty aka “Firewall” Increased in late March 2012 to €500m, starts 7/2012, fully ready by 2014 (!) Probably still too small (German objections; France + others wanted €1 tn EFSF + ESM limit is €700 bn European Monetary Fund (EMF) starts July 2012 Andrew Rose, EMU

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

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

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

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

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

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

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 Andrew Rose, EMU

Hence More Fiscal Austerity Considerable pressure on Greece to raise taxes, cut spending (and exacerbate 4-yr recession) Portugal, Spain, Ireland too German View: Roasting the Meat (or Burning it?) But … will this work? The markets don’t think so Most commentators agree with markets Right way to approach the problem? Andrew Rose, EMU

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

“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

But if Two Regions have Asymmetric Business 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

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

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

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

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

Competitiveness within EMU 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Real Effective Exchange Rate (1999=100) Germany 100.0 93.3 94.3 99.4 101.1 99.3 98.6 100.5 101.6 96.8 Greece 93.4 94.6 97.5 103.9 106.0 106.4 107.4 109.3 112.4 113.8 113.7 Portugal 97.6 102.5 107.2 108.5 109.1 110.8 111.7 110.9 108.6 Current Account Balance (% of GDP) -1.3 -1.7 0.0 2.0 1.9 4.7 5.0 6.3 7.5 5.7 -5.4 -7.8 -7.2 -6.5 -6.6 -5.9 -7.5 -11.2 -14.3 -14.8 -11.0 -10.6 -8.2 -10.4 -10.3 -8.4 -10.7 -10.1 -12.6 -10.9 -9.9 Andrew Rose, EMU

Bottom Line Greece has a fiscal problem But solving it (if possible) won’t restore growth Real problem: poor competitiveness limits growth, employment No easy solution for that Hence … more serious crisis inevitable Could easily be worse than Lehman Andrew Rose, EMU