Recent Developments in Europe and International Financial Markets: Much Ado about EMU Andrew K. Rose Berkeley, Haas 1Andrew Rose, EMU

One Big Potential Threat International Financial Markets are worried about EMU – Distress throughout 2010 and 2011 – Relative Calm early in 2012 Draghi’s trillion euro loans to banks – Fears now Returning “Austerity Fatigue” Many Elections Andrew Rose, EMU2

Beware Greeks Bearing Bonds Sovereign default was inevitable – So far voluntary; “disorderly” to come? – Ireland? Portugal? Spain? 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, EMU3

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, EMU4

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, EMU5

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 6Andrew Rose, EMU

Convergence Criteria, 1 Institutions – Central bank independence – Easy! 7Andrew 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! 8Andrew 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! 9Andrew Rose, EMU

Convergence Criteria, 4 Exchange Rates – Fixed Exchange Rates within “normal bounds” (15%!) – No realignment within last two years – Once more: easy! 10Andrew Rose, EMU

Convergence Criteria, 5 Fiscal Positions Members must have “Sustainable Government Financial Position” defined as: a)Flow: Deficit/GDP ratio of less than 3%, and b)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 11Andrew 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 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, EMU13

How Should One Think about EMU? Economists (and Haas MBA students) usually ask two questions on EMU 1.“Do European Countries look like an ‘Optimum Currency Area’?” 2.“Are European Countries similar to American Regions?” 14Andrew Rose, EMU

“Optimum Currency Areas” Mundell’s Nobel Idea: When are two regions more likely to gain from common currency? 1.If they share deep trade links and – Single currency reduces transaction costs of trade 2.If they have similar business cycles – Same monetary policy appropriate 15Andrew 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 16Andrew 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) 17Andrew Rose, EMU

An Alternative Adjustment Method Factor Mobility – Unemployed workers move to places of high demand – Relieves unemployment and inflation 18Andrew Rose, EMU

Mundell’s “Optimum Currency Area” 1.Suppose business cycles are asymmetric, and 2.There is a) little risk-sharing, and b) immobile labor, then 3.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) 19Andrew 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, EMU20

Competitiveness within EMU Real Effective Exchange Rate (1999=100) Germany Greece Portugal Current Account Balance (% of GDP) Germany Greece Portugal Andrew Rose, EMU21

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, EMU22

Second Potential Threat: Global Imbalances America’s Current Account Deficit – 2006: $811.5 billion deficit (!) >6% of American GDP Implies annual Capital Inflows of $2700 per person annually (!) – Almost all Goods (Services in surplus but small) Small persistent income surplus Andrew Rose, EMU23

Causes Some Dispute among Economists Still, Low American Savings chief reason – Personal Savings very low lately, often negative – Public Sector also dis-saving (Federal deficits) Lack of Investment outside US also possible issue Poor Savings opportunities outside US? Andrew Rose, EMU24

US Current Account Deficit: Sustainable? Size of Deficit unprecedented for America Also unprecedented for “Anchor” country US now taking over 75% of all global savings flows Capital running “uphill” from poor to rich (!) Growing US external debt Andrew Rose, EMU25

Things that Can’t Go On Forever … Don’t US current account imbalance has shrunk dramatically since 2006 Now ≈ 3% GDP (lower, but high) Which leads us to Asia … Andrew Rose, EMU26

Asian Development Strategy Asians take Exchange Rate Policy Seriously Almost all East Asians manage currencies, will continue to do so Part a Legacy of Asian Crisis of ’97-’98 Mostly a Development Strategy … Andrew Rose, EMU27

China Especially Chinese Communist Party Needs Growth to Survive Politically – Growth is Required to Absorb Massive Unemployment in Chinese Countryside Agricultural Peasants Must Be Transformed Into Manufacturing Workers – Exports Provide Only Possible Outlet Andrew Rose, EMU28

Implications for West China had incentive to maintain under-valued exchange rate – Under-valuation the key to rapid export growth – Right in theory – Effective in practice (past twenty years!) – Hence rapid accumulation of US$ reserves, as China maintains under-valued peg to US – Reserves act as “collateral”, encourage FDI Andrew Rose, EMU29

Special Role of USA US is issuer of $, global reserve currency East Asians fixes against US$ US is largest, most open economy US willing to handle large, persistent current account deficits Andrew Rose, EMU30

Calm Breaking Out? Yuan now appreciating in both nominal and real terms; dollar depreciating Current Accounts returning to more normal levels Andrew Rose, EMU31

Current Accounts, Exchange Rates Current Accounts (% GDP) China US Exchange Rates China, Real Yuan/$ US, Real Andrew Rose, EMU32

Bottom Line Worry about Europe, not China Andrew Rose, EMU33