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

2. Understanding the European Crisis What are the risks of a European Sovereign Debt Crisis? – Financial Markets: risks non-trivial but low Currently (4/20) Greek 10-yr bond rate ≈ 13.3% – Economic and Political Fundamentals remain poor Recession ended, but growth slow, unemployment high Syriza elected 1/2015 to end austerity IMF, EC, Germans seem implacable – Who’s Right? The Markets or the Fundamentals? Andrew Rose, EMU2

3. How can we understand the Euro Crisis? What are the underlying causes? – Political, Economic, and Financial Are the policy makers and markets correct in their diagnoses? – Probably Not What are the potential implications for Europe and the rest of the world? – Potentially disastrous Andrew Rose, EMU3

4. Beware Greeks Bearing Bonds Sovereign default was inevitable – So far voluntary; “disorderly” to come? Current Greek 10-yr bond ≈13% (way down) – German ≈.1% (US, UK, Japan very low too) Government Debt unsustainable (≈175% GDP) – German ≈ 75% Big government deficits gone now – Greek “primary surplus” before interest Andrew Rose, EMU4

5. 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, EMU5

6. 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, started 7/2012, fully ready by 2014 (!) – Probably still too small (German objections; France + others wanted €1 tn) – EFSF + ESM limit is €700 bn – Draghi, Sept 2012: ESM approval implies unlimited ECB support, will do “what it takes” European Monetary Fund (EMF) started July 2012 Banking Union (ECB at center) started Nov 2014 – single supervisor Andrew Rose, EMU6

7. 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 7Andrew Rose, EMU

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

9. Convergence Criteria, 2 Inflation – CPI inflation within 1.5% of target – Target is average inflation of three countries with lowest inflation – Still easy! 9Andrew Rose, EMU

10. 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! 10Andrew Rose, EMU

11. Convergence Criteria, 4 Exchange Rates – Fixed Exchange Rates within “normal bounds” (15%!) – No realignment within last two years – Once more: easy! 11Andrew Rose, EMU

12. 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 12Andrew Rose, EMU

13. 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, via “Six Pack” (2011) and surveillance in “Two Pack” (2012) 13Andrew Rose, EMU

14. Hence More Fiscal Austerity Considerable pressure on Greece to maintain/raise taxes, cut spending (after 5-yr recession!) – Portugal, Spain, Ireland too – German View: Roasting the Meat (or Burning it?) But … will this work? – The markets aren’t panicked – Most commentators agree with markets Right way to approach the problem? Andrew Rose, EMU14

15. 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?” 15Andrew Rose, EMU

16. “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 16Andrew Rose, EMU

17. 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 17Andrew Rose, EMU

18. 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) 18Andrew Rose, EMU

19. An Alternative Adjustment Method Factor Mobility – Unemployed workers move to places of high demand – Relieves unemployment and inflation 19Andrew Rose, EMU

20. 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) 20Andrew Rose, EMU

21. 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, EMU21

22. Competitiveness within EMU Andrew Rose, EMU22 19992005200820092010201120122013 Real effective exchange rate (2010 = 100) Germany101.3100.0101.5102.397.396.593.094.5* Greece94.5100.0105.4106.9106.7107.5104.1103.2* Portugal92.7100.0102.7102.1100.0100.899.599.8* Spain90.9100.0106.1106.3103.7104.3102.101.2* Current account balance (% of GDP) Germany-1.35.16.26.06.36.27.08.0* Greece-5.5-7.6-15.0-11.2-10.3-9.9-3.5-.7* Portugal-8.7-10.3-12.7-11.0-10.0-7.1-1.6-3.0* Spain-2.9-7.4-9.7-4.8-4.6-3.5-1.1-1.9* Unemployment Rate Germany8.411.17.57.77.15.95.25.1* Greece11.79.87.79.512.517.727.626.7* Portugal4.47.6 9.510.812.715.615.3* Spain15.69.211.318.020.121.626.026.0*

23. Bottom Line Greece has a fiscal problem – But solving it (if possible) won’t restore growth – Difficult to sustaining pro-cyclic fiscal policy Real problem: poor competitiveness limits growth, employment (Portugal, Spain too!) – Bubble overhangs also No easy solution for that Hence … more serious crisis inevitable – Could easily be worse than Lehman Andrew Rose, EMU23