1. THE EURO CRISIS – WHAT HAVE WE LEARNED AND WHAT CAN BE DONE? Christopher A Pissarides Regius Professor of Economics London School of Economics Essex 50 th birthday celebrations, 12 June 2015 1

2. The Eurozone crisis The European Union is clearly not delivering what it promised with the single currency What is needed to bring it back to robust growth? Does the fault for the prolonged crisis lie with the structure of labour markets or with monetary and fiscal policies? Will argue that crisis is due to mismanagement of a single currency when the optimal criteria for an optimal currency area are not satisfied 2

3. Labour markets in crisis? European labour markets have become inflexible Many reformed: UK in the 1980s, Netherlands in early 1990s, Germany in 2002-2005 Reforms are essential in Europe for competitiveness and adoption of new technologies Debt management and inflexible labour markets got confused with bad outcomes for each 3

4. Optimal Currency Area? OCA requires similar economic structures and business cycles to reduce the risk of different policy requirements The crisis exposed differences due mainly to relative size of construction sector and debt It requires labour and capital mobility to correct imbalances that may require different policies Although free, these don’t work as correction mechanisms 4

5. Optimal currency area Fiscal transfers can also offset imbalances, often recommended in addition to factor mobility But the Eurozone does not allow them – Maastricht criteria meant to remove the need for them 5

6. Fiscal transfers have been critical in countries where monetary union worked United States when West opened up: infrastructure was provided with East Coast money German unification: East Germany was kick-started with West German money In both cases we had political union! EZ is using them as the main tool to correct imbalances between members: ESM, various rescue packages, ECB QE 6

7. Are economies in the Eurozone similar to each other? Originally yes - Greece was probably the first country to be admitted with less similar structure (more agriculture, more trade with Balkans and East) But recent crisis exposed some unanticipated dissimilarities between members with bad consequences Ireland, Spain, Portugal and Cyprus grew very large construction sectors Smallest construction sector about 6% of employment before the crisis and majority below 8.5%. Greece at 8.8% but other “crisis” countries 10.7-13.3% 7

8. Construction employment shares, 2007 (in red: program countries) 8

9. Implications Crisis started in the housing sector – so countries with bigger construction sectors received a bigger shock Banks had over-extended loans in this sector; governments guaranteed them to avoid run on the banks So the negative impact of the housing shock in these countries was reinforced by public debt explosion that forced contractionary fiscal policy 9

10. Why no debt crisis in the Baltics and why in Greece? In the case of the two Baltic states their large construction sectors seemed to be justified by their large growth rates following transition In the case of Greece the problem was not so much the bursting of a construction bubble but a large public debt accumulation prior to crisis 10

11. Correlation between construction sector size and growth rates 11 POR SPAIRL LAT

12. Correlation between construction sector size and growth rates 12 LAT

13. Labour market responses With flexible exchange rates, when big negative shock hits a sector like construction demand for imports falls and exchange rate depreciates In a common currency area we need other corrections Out-migration Fiscal transfers Failing these “internal depreciation”, namely, wage reductions 13

14. Internal depreciation Forced on programme countries But unemployment needs to rise substantially to trigger the internal depreciation and it did, making the recession worse 14

15. Unemployment change 2007-2012 15

16. Did recession trigger the right labour market response? Nominal and real wages fell everywhere in the periphery but only in Greece to a non-trivial degree: 17% fall in real average earnings Although there was some deflation prices largely held up 16

17. Real average earnings 2012 (2009=100) ownRelative to Germany Ireland97.094.2 Italy97.994.0 Spain96.895.1 Portugal90.687.9 Greece82.580.1 17

18. Did wage adjustments bring the right results? Biggest failure of the combined programmes of debt reduction and economic restructuring Massive fiscal retrenchment was reinforced by real wage reductions that spilled out to the whole economy Classic Keynesian response of labour markets: negative fiscal multipliers reinforced instead of being offset by wage reductions 18

19. Why didn’t wage reductions work? For standard Keynesian reasons: deflation does not get a country out of a recession, especially one with large debts Wage and pension reductions accompanied by a fall in government spending, tax rises and dysfunctional (home- biased) banks reduce aggregate demand catastrophically The real value of debt rises; the troika forces further spending cuts to reduce the debt to GDP ratio; deflation gets worse A vicious circle that leads to more debt and unemployment 19

20. Labour markets at fault? Ireland has flexible labour markets: its aggregates are similar to other countries hit by the construction shock The key reason for Europe’s labour markets not working is the deflationary shock following the debt crisis Compare Ireland (flexible labour markets) with Spain (inflexible labour markets) 20

21. GDP per head 2007=100 21

22. Employment rates 2007=100 22

23. Monetary policy The obvious alternative to fiscal austerity is expansionary monetary policy The ECB needed to create more inflation that would depreciate the euro and reduce the real burden of the debt; err on the upside on its inflation target Bank of England followed similar policy when Coalition government imposed debt-reduction fiscal policies in 2010 ECB eventually acted (March 2015) 23

24. Could the ECB balance them out? (Inflation target “just below” 2%) December 2014 figures (all per cent) Inflation unemployment Germany 0.84.9 Southern periphery -0.218.6 Eurozone 0.411.5 24

25. ECB policies Given unemployment rates, correct monetary management of common currency area required erring on the upside, not the downside ECB tolerated 0.4% inflation with a target of just below 2%, it could have tolerated 3% Low debt countries had nothing to fear from it, high debt countries would have benefited 25

26. Debt burdens Debt burdens are tolerable now because of very low interest rates and help from IMF and ECB/Commission But when interest rates start to rise they will become unsustainable – inconsistent with fast growth Need to find a way of reducing the debt burden This inevitably will involve some kind of “haircut” 26

27. Investment and growth But more importantly, we need more investment and productivity growth Germany doing well in Europe – but the average EU performance is appalling Need to find a way of financing investments, e.g., draw distinction between money lent for investment and money lent to finance budget deficits Otherwise we will keep falling behind 27

28. Domestic R&D, 2012

29. Fixed capital formation, private

30. Fixed capital formation, public

31. Labour markets Labour markets are not to blame NOW but don’t lose sight of the fact that monetary union requires flexible labour markets Many countries, especially in the South, still lack flexibility Recent structural reforms are in the right direction but they are taking time to have a positive impact and they need the cooperation of all social partners 31

32. German reforms The German reforms of 2002-05 tool place in favourable conditions and still had their impact 4 years later German officials point out that it was great help that rest of Europe was growing and they broke the Maastricht deficit criteria to help implement the reforms Exactly what Greece and the others are not allowed to do now! 32

33. Future of Europe Do the Eurozone countries have the political will to cooperate further to restore balance in economic performance? If not, future of Eurozone and EU bleak 33