Much Ado about EMU Andrew K. Rose Berkeley, Haas 1Andrew Rose, EMU

Beware Greeks Bearing Bonds Sovereign default now inevitable – Hopefully voluntary; otherwise “disorderly” 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, EMU2

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” 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 Andrew Rose, EMU3

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 4Andrew Rose, EMU

Convergence Criteria, 1 1. Institutions (easy) – Central bank independence 2. Inflation (easy) – CPI inflation within 1.5% of target; – Target is average inflation of three countries with lowest inflation 3.Interest Rates (easy) – Average long-term interest rates within 2% of target; – Target is average long-term interest rate of the three low-inflation countries 5Andrew Rose, EMU

Convergence Criteria, 2 4.Exchange Rates (easy) – Fixed Exchange Rates within “normal bounds” (15%!) – No realignment within last two years 5.Fiscal Positions: 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 6Andrew Rose, EMU

Stability (and Growth) Pact EMU “Ins” should maintain deficits of less than 3% GDP 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 3-yr recession) – Portugal, Spain, Ireland too But … will this work? – The markets don’t think so – Most commentators agree with markets Right way to approach the problem? Andrew Rose, EMU8

How Should One Think about EMU? Economists (and Haas students) usually ask two questions on EMU – “Do European Countries look like an ‘Optimum Currency Area’?” and – “Are European Countries similar to American Regions?” 9Andrew 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 (single currency reduces transaction costs of trade) 2.If they have similar business cycles (same monetary policy appropriate) 10Andrew 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 11Andrew Rose, EMU

Possible Methods to Adjust (to Asymmetric Business Cycles) 1.Sharing risks via public sector (system of taxes and transfers) – Or via private sector (international cross-holdings of assets) 2.Factor mobility (unemployed workers move to places of high demand) 12Andrew 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) 13Andrew 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, EMU14

Competitiveness within EMU Real Effective Exchange Rate (1999=100) Germany Greece Portugal Current Account Balance (% of GDP) Germany Greece Portugal Andrew Rose, EMU15

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, EMU16