1. Economic Experience and Crisis in the Euro Zone Carlos Hurtado* The Restructuring and Resolution of External Sovereign Debt World Bank. Annual Law, Justice and Development Week *Economic consultant, LCSPR, World Bank. The views are personal and do not reflect necessarily those of the World Bank

2. Background. History of the EEC and Path to the Monetary Union in 1999 1975: European Economic Community, EEC Custom union, common market 1985: Schengen Rules Free migration 1992: Maastricht Treaty. Three pillars: Foreign Policy and Security, Justice and Home Affairs, and European Community …leading eventually to Economic and Monetary Union (EMU) 1999: Beginning of the Euro zone, Euro as a common currency, with 11 countries (of the 15 members of the EC) Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, The Netherlands, Portugal, and Spain Further accession: Greece (2001), Slovenia (07), Cyprus and Malta (08), Slovakia (09), Estonia (11)

3. “ The Law”: The Treaty of the European Community. Convergence Criteria The Maastricht or Convergence Criteria (1992), defined in art. 121 of the Treaty Establishing the European Community (EC) and its protocols, in order to maintain stability of the EC  Inflation: no more than 1.5 %pts., above the average of the 3 lowest inflation countries (“reference value”)  Public Deficit: equal or below 3% of GDP  Public Debt: equal or below 60% of GDP  Interest Rates: no more than 2 %pts., above the average of the 3 lowest inflation countries (ref. value)  (2 Years under the exchange rate mechanism ERM II) Note: The idea is either to comply or to be on the compliance track

4. 1998: Compliance with the Maastricht Criteria Complying. Germany, Spain and Austria just exceeded the Debt target Not complying. Most entered the Euro Zone in 1999. Greece in 2001

5. Country Risk and the Common Currency Ten-Year Bond Yields before and after Adoption of the Euro Source: Bergsten and Funk (2012). Country risk suddenly disappeared with the adoption of the common currency, while the Treaty did not consider bailout provisions or any form of debt “mutualization” Countries and markets behaved as if sovereign debt had an implicit guarantee from the Union To no surprise, capital inflows poured into relatively capital-scarce countries: Greece, Ireland, Portugal and Spain

6. The Euro Experience 1999-2007 In general, according to expectations: significant resource absorption and investment, higher current account deficits and growth, and declining unemployment* Convergence towards the German economy Greece and Portugal: increased public deficit and debt Ireland and Spain: public finances actually improved but absorbed financial flows in a typical “bubble” fashion The EU lost competitiveness significantly. Unit labor costs increased steeply everywhere, except Germany, and the real exchange rate appreciated * Exceptions: Growth was modest in Portugal and Italy; unemployment actually increased in Portugal; and investment declined in Portugal and Greece

7. Unit Labor Costs in Troubled European Economies v.s. Germany

8. 2007: Compliance with the Maastricht Criteria Not complying: Still Greece, Portugal, Belgium and Italy*, plus Germany* and France* Complying: Notably Spain and Ireland, plus all the newer membership *Italy, Germany and France showed “excessive” fiscal deficits in the first half of the years2000

9. Why is adjustment so difficult After 2007, stagnation and high unemployment in the UE, especially in the most troubled: Greece, Ireland, Portugal and Spain* Inherent problems:  Impossibility of nominal depreciation forces “fiscal” depreciation: nominal reductions of wages, public expenditure, debt…  Imperfect migration: e.g. contrasting unemployment rates in Germany and Spain  No fiscal union: lack of solidary system  No banking union  Uncertainty about backstop mechanism. Implicit belief that the EU would be LOLR, although the ECB legislation explicitly prohibits it  Lack of full recognition of the necessity to reduce debt significantly in insolvency cases (e.g. LA in the 80-90s)  Use of politically costly mechanisms to provide help to Greece *The first three, under programs with conditionality –very difficult to comply

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11. Outline for Presentation 1.Background. History of the EEC and path to the monetary union in 1999 2.The Law: The Treaty of the European Community. Convergence criteria and limits on intervention 3.How the 11 countries looked vs the convergence criteria before accession (incl. Greece) 4.How the country risk disappeared after 1999 and $ poured into the relatively LDC’s 5.Bonanza between 1999 and 2007, and deterioration of imbalances 6.How the 17 countries looked vs the convergence criteria in 2007 7.Why is adjustment so difficult – Lack of stronger federation-like union (fiscal, solidarity, banking reg., migration…) – Limits to bailouts. ECB limitations (treaty), political constraints