Euro Crisis Dec 2010

8/3/2019 Euro Crisis Dec 2010

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Creating the Monetary Union

led to the current crisis, butbreaking up the Euro would be

difficult and costly

by

Assaf Razin

December, 2011


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The creation of the euro should now be

recognized as an experiment that has led tothe sovereign debt crisis in several countries,the fragile condition of major European banks,the high levels of unemployment, and thelarge trade deficits that now exist in mostEurozone countries.

Although the European CentralBank managed the euro in a way thatachieved a low rate of inflation, othercountries both in Europe and elsewhere havealso had a decade of low inflation withoutincurring the costs of a monetary union.


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What led to Monetary Union

The initial impetus that led to the EuropeanMonetary Union and the euro was actually

political rather than economic. Politicalleaders generally favored the creation ofthe euro as a step toward deeper

political integration.

The shift of responsibility for monetarypolicy from national capitals to a singleEuropean Central Bank in Frankfurt would

signal a shift of political power.


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History

The Treaty of Rome launched the Common

Market in 1957.

The Common Market developed into theEuropean Economic Community in 1967and the European Union in the Maastrichttreaty of 1992, creating not only a largerfree trade area but also providing for themobility of labor and other aspects of anintegrated European market for goods and

services.


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Monetary Union

The political process evolved through theMaastricht Treatys creation of the

European Monetary Union and the plansfor the single currency which eventuallybegan in 1999


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A single currency means:

1. that all of the countries in the monetaryunion have the same monetary policy andthe same basic interest rate, with interestrates differing among borrowers only

because of perceived differences in creditrisk.

2. A fixed exchange rate within the

monetary union and the same exchangerate relative to all other currencies, evenwhen individual countries in the monetary

union would benefit from changes in


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The Euro Deal

As the euro became a done deal,countries that had previously had to pay alarge interest premium found themselvesable to borrow on the same terms asGermany; this translated into a big fall intheir cost of capital. The result was

bubbles, inflation, and in the aftermath ofthe bubbles and inflation.


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When a county has its own monetary policy, it canrespond to a decline in demand by lowering interest ratesto stimulate economic activity.

But the European Central Bank must make monetarypolicy based on the overall condition of all the countriesin the monetary union.

This means interest rates that are too high for thosecountries with rising unemployment and too low in othercountries where wagesare rising too rapidly.


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The shift to a monetary union and the toughantiinflationary policy of the European CentralBank caused interest rates to fall in countrieslike Spain and Italy where expectations of highinflation had previously keptinterest rates high.

Households and governments in thosecountries responded to the low interest ratesby increasing their borrowing, withhouseholds using the increased debt tofinance a surge in home buildingand house prices while governments borrowedto finance budget deficits that accompaniedlarger social transfer programs.

The result was rapidly rising ratios of public

and private debt to GDP inseveral countries, including Italy, Greece,Spain and Ireland. Despite theincreased risk to lenders that this implied,the global capital markets didnot respond by raising interest rates on

countries with rapidly risingdebt levels.


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A different market dynamic affected therelation between the commercial banks andthe European governments. Since the

banks were heavily invested in governmentbonds, the declining value of thosebonds hurt the banks.


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During the euro-bubble yearsthere were huge capital flows to

peripheral economies, leadingto a sharp rise in their costs

relative to Germany


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Capital inflows to Spain


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Now that the bubble bursts,should the adjustment be rising

wages in Germany or fallingwages in Spain? The ECBsignals that no inflation inGermany will be tolerated. The

recipe is for a prolonged slumpin the periphery.


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Fiscal Federalism

The transfer of economic resources frommembers with healthy economies tomembers who suffer economic setbackcan best be done through fiscalfederalismmost of the risk is privatelyuninsurable.

This is a key difference between US andEurozone. It remains to be seen whetherthe EU will develop more elaborate

institutions for carrying out fiscal transfers


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Iceland vs. Ireland

Icelands positive swing has been abouttwice as large as Irelands and weretalking an extra 10 points of GDP here.Thats a lot of extra stimulus, and to theextent that it was due to devaluation, thatsa major plus for having your own currency


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UK Government Bonds vs. Spain

Government Bonds Financial markets can force monetary

union countries sovereigns into default.

The financial markets attach a muchhigher default risk on Spanish than on UKgovernment bonds. In early 2011 thisdifference amounted to 200 basis points.


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UK Government Bonds

Suppose that investors fear that the UKgovernment might be defaulting on its debt.They will sell their UK bonds, driving up the

interest rate. After selling these bonds theseinvestors would have pounds that they wouldwant to get rid of by selling them in the foreignexchange market. The price of the pound would

drop until somebody else would be willing to buythese bonds. UK money stock will remainunchanged.


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Investors cannot precipitateliquidity crisis for a non sigle

currency area country

Even if the UK government cannot find the

funds to roll over its debt it would force theBank of England to buy up the governmentsecurities.

Thus, investors cannot precipitate aliquidity crisis in the UK that could forcethe UK government into default.


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e t ynam cs: mem er o asingle currency area and non

member UKcurrency depreciation follows

sovereign debt crisis and inflation

increases. Real value of debt falls.

SpainTo regain competitiveness wages

are cut following sovereign debt crisis.Deflation raises the real value of the debt.


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Internal depreciation vs. Real

Depreciation The only way is to reduce costs, relative tocountries inside and outside the currencyarea. Economists sometimes refer to thisas a real depreciation orinternaldevaluation. That requires slower priceand wage growth or faster productivity

growth than elsewhere. Given todays lowinflation rates, it means outright declines inprices and wages.


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Inflation in the north deflation

in thesouth Real exchange rate changes within a

currency area come about with inflation inthe north deflation in the south. But ifthe north pursue strict anti-inflationpolicy, deflation in the south is enhanced.


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Competitiveness within the Euro-zone: decade and a half before the

crisis Greece, Ireland, Portugal and Spain lost

a lot of competitiveness:

Low interest rates led to a surge indomestic demand. And sharp rises in realwages.

Productivity growth was not vigorousenough to compensate.


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Debtcrisis and fixed

exchangerate:lessons from Latin America

Argentina is a case in point. In 2001, it ranthrough a series of governments beforetriggering the worlds then-biggest default($100bn; so small compared to Italys

1.9tn bond market).


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To restore competitiveness without breakingArgentinas euro-like currency peg, heengineered a synthetic devaluation . Across-the-board export subsidies and import dutiescame straight out of the textbooks, but didntwork. Just as they often do in Europe today,

investors saw the countrys debt dynamics stillworking against it.


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Restoring competitiveness

against bad debt dynamicsTo restore competitiveness withoutbreaking Argentinas euro-like currencypeg, he engineered a tax-baseddevaluation. Across-the-board exportsubsidies and import duties came straightout of the textbooks, but didnt work. Just

as they often do in Europe today, investorssaw the countrys debt dynamics stillworking against it.


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Bad debt dynamics

Default fears led to higher bond yields,which led to lower growth and smallergovernment revenues. This made defaultmore likely in a process that soon became

self-fulfilling. After three years ofrecession, much of southern Europe mayalready on the brinks of default.


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Trends in Euro zone

Prolonged recession

Beyond Greece there will be more debt

restructurings Banks will be nationalized

ECB buys debtprice stability plays back

role to financial stability


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Three difficult-to-solve Problems

1. Absence of adequate adjustmentmechanism to correct current accountimbalances among member states.Internal devaluation lead to currencymismatch on a members balance sheet.The result: Heavily indebted,

uncompetitive, countries. 2. Absence of bank regulation at the level

of the union leads to race-t-the-bottom

regulation competition among members.


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3. Inadequate supply of liquiditybecause national governments

in the south have limitedcapacity to issue and redeem

safe assets that can be boughtand sold at predictable prices.The ECB is reluctant to be a

lender of last resort to nationalgovernments.


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Sovereign Debt And Banks

By the fall of 2011, several Europeancountries had debt to GDP ratios

that made default a serious possibility.Sharp writedowns in the value of theirsovereign debt would do substantialdamage to the European banks andpossibly to banks and other financialinstitutions in the United States.


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Strategies to deal with

this situation1. The Eurozone leaders agreed inOctober 2011 that the banks should

increase their capital ratios and that theEuropean Financial Stability Facility(EFSF) should be expanded from 400

billion euros to more than a trillion Euros toprovide insurance guarantees that wouldallow Italy and potentially Spain to accessthe capital markets at reasonable interest

rates.


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2. All 17 members of the Eurozone, plus 6other countries who wish to join the Euroone day, signed in December 2011, anintergovernmental pactthat wouldenforce stricter fiscal discipline. Sanctionswill be imposed on countries that fail to

stay with limits of budget deficits, insertingbalance budget legislations of members,with the European Court in charge.


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This plan to increase the banks capitalwont work because the banksdont want to dilute current shareholders by

seeking either private or public capital.Instead, they are reducing their lending,particularly to borrowers in other countries,causing a further slowdown in Europeaneconomic activity.


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2. The second strategy calls for theEuropean Central Bank to buy thebonds of Italy, Spain and other high debt tokeep their interest rates low.

The ECB has already been doing that to alimited extent but not enoughto stop Greek and Italian rates fromreaching unsustainable levels.


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3. The third strategy is favored by thosewho want to use this crisis toadvance the development of a political

union. They call initially for atransfer union or a fiscal union in whichthose countries with budgetsurpluses would transfer funds each yearto the countries runningbudget deficits and trade deficits.


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Greece

The Greek budget deficit of 9 percent ofGDP is too large to avoid a further outrightdefault on its national debt. With a current

debt to GDP ratio of 150 percent and thecurrent value of Greeces GDP falling in

nominal euro terms at 4 percent, the debtratio would rise in the next 12 months to170 percent of GDP. Rolling over the debtas it comes due and paying higher interestrates on such debt would raise the total

debt even more quickly.


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Cutting the interest bill in half by a 50percent default while balancing the rest ofthe budget would only reduce the deficitvery slowly, from 150 percent now to 145percent after a year, even if no paymentsto bank depositors and other creditors

were required. It is not clear that financialmarkets will wait while Greece walks alongthis fiscal tightrope to a sustainable debtratio well below 100 percent.


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Italy is much better

Italy already has a primary budget surpluswith tax revenue exceeding noninterestgovernment outlays by about one percent

of GDP and a slightly positive rate ofgrowth. With interest on the national debtnow equal to about 5 percent of GDP,

Italys total budget deficit is about fourpercent of GDP. A two percent of

GDP reduction of that deficit would beenough to start a decline in the ratio of

debt to GDP.


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But this is not going to solve the

competitiveness problemReducing the problem of large budgetdeficits and the related problem of thecommercial banks that have invested ingovernment bonds would still not solve thelongterm competitiveness problemcaused by monetary union.


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Leaving the Euro?

The alternative is for Greece to leave theEurozone and return to its own currency.Although there is no provision in theMaastricht treaty for a country to leave,political leaders in Greece and othercountries are no doubt considering that

possibility for Greece. While Greece iscurrently receiving transfers from the otherEurozone countries, it is paying a veryhigh price in terms of unemployment and


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Bank crises in Greece?

The primary practical problem of leavingthe euro is that some Greek businessesand individuals have borrowed in Eurosfrom banks outside Greece. Since thoseloans are not covered by Greek law, theGreek government cannot change the

obligation from Euros to New Drachmas. The decline in the New Drachma relative

to the euro would make it much more

expensive for the Greek debtors to repay


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Strings attached

But Germany is now prepared to subsidizeGreece and other countries to sustain theeuro, Greece and others mightnevertheless decide to leave if theconditions imposed by Germany aredeemed to be too painful to accept.


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But breaking up the Monetary

Union would be difficult andcostly.


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Ireland Boom

Philip Lane ofTrinity College notes: Therewas a genuine Irish economic miracle,with very rapid output, employment andproductivity growth during the 1994-2000period. Without entry into the eurozone,this might have petered out. But the fall in

interest rates increased the risk that acredit-fuelled property bubble wouldemerge. So, indeed, it did.


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Ireland Bust


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The ratio of private credit to GDP jumped fromaround 100 per cent in 2000 to 230 per cent in2008. Foreign lenders played a huge role infunding this boom: the net foreign liabilities of

domestic banks went from 20 per cent of GDP in2003 to over 70 per cent in early 2008.

The global financial crisis caused animmediate cessation in the capital inflows.In panic-stricken response, the Irish

government guaranteed bank debt inSeptember 2008. As the fiscal costsmounted, driven by the slump and theneed to rescue the banks, what began as afinancial crisis ended up as a crisis inpublic debt.


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The direct costs of recapitalizing the systemare set to be around 36 per cent of GDP.Forcomparison, the cost of the Asian financialcrisis to South Korea was 31 per cent of GDP,while the cost of todays crisis to Icelandmight be only 13 per cent of GDP. On the last,according to the IMF, general government

debt could be 123 per cent of GDP by 2014. Alittle over a third of this increase in the publicdebt ratio would then be a direct result ofrecapitalizing the banks


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Irelands Banks run

Ireland borrowed massively to stop itsrun70 percent of GDP, including $90billion from the European Union Loan,

leaving the country with more debt-to-GDPthan Greece.

By saving the banks, and their creditors,the government bankrupted the country.

Unemployment is 14 percent and output isdown by 10 percent.


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Ireland Debt Overhang

The overhang of toxic debt accumulated after a decadein which Irish banks borrowed in the internationalwholesale markets to finance a property developmentbubble.

Following the burst of the bubble the governmentcommitted 50 billion Euros-one third of GDP-to fill thehole.

Back in 2008 the government gave 100 percentguarantee to all bank deposit and to most of their debt.

By September and October 2010 ECB lent to Irish banksone quarter of all ECB lending to Eurozone banks.


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sector debt

crisis


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Irelands volatile FDI inflows


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Spain

These big capital inflows raised demandfor Spanish goods and services, leading tosubstantially higher inflation in Spain than

in Germany and other surplus countries.

Both countries are on the euro, so thedivergence reflects a rise in Spains

relative prices.


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Spain: The aftermath of thehousing bubble

When the bubble burst, it left Spain with muchreduced domestic demand, and highlyuncompetitive within the euro area thanks to therise in its prices and labor costs.

If Spain had had its own currency, that currencymight have appreciated during the real estateboom, then depreciated when the boom wasover.

Since Spain does not have its own currency itseems doomed to suffer years of grindingdeflation and high unemployment.


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Relative Price ofNon-Tradables


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Where are Spains budget deficitsin all this?

Spains budget situation looked very goodduring the boom years.

It is running huge deficits as a consequence,not a cause, of the crisis:

Tax revenue has plunged, and thegovernment has spent some money trying

to alleviate unemployment.


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The Crash of 2008 and the rescueof the banks

In the absence of the lender of last resort forthe ECB, there is a risk to the Euro when eachmember state attempts to rescue the banksindependently.

In the aftermath of the financial crisis Spain,Greece, Italy, and Ireland created huge budgetdeficits

The European authorities must coordinate arescue package across different member statesto facilitate fiscal consolidation of high deficitcountries.

But how sharp could be the budget cuts?


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Greece: A Vicious circle

Greek high budget deficits raise the riskpremium on Greek government bonds.

High risk premium puts Euro arrangements at

risk. Euro authorities for budget cuts.

Budget cuts depress economic activity andreduce tax revenues.

The further increase in the deficit raises the riskpremium on Greek government bonds.

Etc., Etc.,


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Sovereign debt spread


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Germany vs. France

S ill b


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Spillover between euro-zonemember states

When investors dump government bonds,they also raise interest rate in thesesbonds and force the government to reduce

its budget deficit. This is likely to reducedownturn; hence increase in deficits. Thusby selling country 1 bonds they also

increase riskiness of government 2 bonds.

I t t i t id i k


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Investors trying to avoid riskcreate more risk elsewhere

The essence of the problem is thatinvestors who sell government bonds ofone country do not take into account the

spillover effects on other country bonds.The problem of contagion is high in euro-zone because of the intensive tradebetween its members.

By forcing early exit strategy in onemember state they also force othermember states to do so.


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Current Account Imbalances

E t l I t l


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External vs. InternalDevaluation

Theeuro allowed these internal

imbalances to grow unchecked and

now stands in the way of a speedyadjustment,becauseeuro-area

countries whose wages are out of

whack withtheirpeers cannotdevalue.


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Integration of Public Finance in theEuropean Union

Makeshift assistance to Greece leavesSpain, Italy, Portugal and Ireland budgetproblems resolved.

Coordinated fiscal consolidation by Eurofinance ministries; and the creation of awell organized Euro bond market for

executing bailouts, seem to be high on theagenda.

The European Commission proposes the

establishment of European Monetary Fund.

P li i l d Fi l U i i


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Political and Fiscal Union requiresFiscal Coordination

The architects of the euro at leastpredicted such problems, even if theycould not solve them. The stability and

growth pact was supposed to limit eachcountrys budget deficit to 3% of gdp andpublic debt to 60% of GDP. It failed, in part

because France and Germany refused toabide by itand even rewrote the ruleswhen they breached the deficit limit.


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A Euro breakup?

No country can be forced off the Euroagainst its will

No country would voluntarily abandon itthe shock of leaving would outweighs anyadvantage of life outside


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Sources of Fiscal Problems

Pro-cyclical behavior by fiscal authoritiesbefore the recent financial crisis

Direct fiscal costs of the financial crisis

Government revenue sources weakenedby the financial crisis

End of asset booms


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Conclusion

The UK economist Charles Goodhart once describedbanks as international in life, but national in death. In the

case of a single currency union you should make themEuropean in death.

Wholesale banking is genuinely cross-border. Germanand UK banks have crippling exposures to Ireland,

French and German banks to Greece, Spanish banks toPortugal. If one peripheral country defaulted, we wouldsee a contagious banking crisis that would overwhelmsome governments ability to cope


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Indebtedness in the Eurozone


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Common Euro Bond

At that point the focus will shift to Italy. Italyaccounts for 18 per cent of the guarantees.I suspect Italy will not be willing to honourits bail-out commitment if and when Spain

were to enter the mechanism. Even if Italywere willing, it might not be able to do it,given its own debt sustainability problems.And once Italy defaults on its commitment,I cannot see Germany and France willingto bankroll the entire system unilaterally. At

that point, the intra-governmental approachwill break down and the eurozone willmake the big jump towards a commonEuropean bond.But a common Eurobond generates moralhazardgives an incentive to excessive

spending.


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Benefits of Currency Union

As we know from the theory of optimumcurrency area, there are benefits andcosts to currency integration.

Benefits are reduced costs of doingbusiness. If they are large, formingcurrency areas lead to large increases in

trade. Intra Eurozone trade has increasedbut not significantly since theestablishment of the EMU.


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Costs of Currency Union

The key problem is building concensus onhow best to stabilize prices andemployment after asymmetric shocks.

Labor mobility (Mundell), Fiscal integration(Kenen), A Strong central bank serving aslender of last recourse, and a fiscal unit to

bailout sovereign debts, lubricateequilibration, but do not automaticallyresolve member conflicting interests.


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LL schedule

Degree ofeconomic integration between the

joiningcountry and theexchangerate area

Economic stability

loss forthe joiningcountry


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The GG-schedule

Monetary efficiency gain The joiners saving from avoiding the uncertainty,

confusion, and calculation and transaction coststhat arise when exchange rates float.

It is higher, the higher the degree of economicintegration between the joining country and thefixed exchange rate area.


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GG schedule

Degree ofeconomic integration between the joining

country and theexchangerate area

Monetary efficiency

gain forthe joiningcountry


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The Extent of Intra European


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The Extent of Intra-EuropeanTrade

Charles Engel and John Rogersdemonstrate the while of pricediscrepancies decreased over the 1990s

(recall the Single Market Act of 1986), nofurther price convergence happened afterthe 1999 Euros introduction.


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Single Currency and Trade

Andy Rose suggested that on average,members of currency union trade threetimes more with each other than with

nonmember states. But Richard Baldwingreatly scaled back to the Eurozoneabout 9 percent increase in mutual trade.


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Asymmetric Macroeconomic


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Asymmetric MacroeconomicShocks

In the first decade of the Euro nominal bondrates converge but--

Inflation rates diverged

Divergence in unemployment rates

Divergences in growth rates

Divergences in budget deficits

Euro Crisis Dec 2010

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