The €uro Needs Rehab...but it will survive

Pierre L. SiklosCIGI, VERC & BSIA

A Political Experiment Gone Bad?

• Well before EMU, the concept was likened as an experiment in international policy coordination (convergence followed by a single exchange rate between sovereign states) enforced by rules (Maastricht): Eichengreen (1992)– …but the main policy actors are Finance Ministers NOT central bankers

• The former group makes policy while the latter ‘cleans up the mess’

– Many of the rules could not easily be defended on purely economic grounds, and little effort was devoted to enforcement after the fact

• The implication? It is fiction to suggest that economics that will save the €; it’s politics

It Gets Worse

• Too few escape clauses in case of stresses in the system• The EU is a weak institution incapable of properly monitoring,

imposing sanctions in case of bad behaviour, and the need for a lender of last resort was wished away

• A tangled web of bank regulation based on national financial market regulators must operate under a single monetary policy

• Was it a mistake? Economically, MAYBE; Politically, NO

What Were They Thinking?

• ECB not designed as a lender of last resort but articles 122/125 of Maastricht (& successors)Treaty does provide a way out– Existing national institutions were left in place

(were they hedging their bets?), weak supra-national fiscal and policy coordination tools

Article 125

Relieving the Pressure: TARGET 2 & LTRO

ReflectsDeposit shiftsSouth to North+Inter-bank Lending difficutlies

Source: Davies, FT May 20, 2012 “The Anatomy of the Eurozone Bank Run” & ECB

€0

€200,000

€400,000

€600,000

€800,000

€1,000,000

€1,200,000

2000 2002 2004 2006 2008 2010

LTRO

Mil

lio

ns

Breaking up is Hard to Do?

• Is an exit strategy essential? Seems exceedingly difficult– Candidates for expulsion – not currently possible on legal grounds - or ones

seeking to leave the € area – nothing to prevent this in law - are already euro-ized

– There are untold legal implications and potentially costly litigation– Ironically, an orderly exit would require the kind of international cooperation

that has since almost vanished– Late night & early morning decisions hardly add trust & credibility to the

possibility of an orderly exit– History of MU – especially in Europe – is littered with break-ups

• Our experiences are with complete break-ups not partial ones

…But no longer impossible?• “…a substantial breach of the existing treaty” …with incalculable consequences

for the bloc, Mario Draghi, ECB President [December 2011]• “I guess an amicable divorce – if that was ever needed – would be possible, but I

would still regret it,” Luc Coene, Governor National Bank of Belgium [May 2012]• “Things can happen that are not imagined in the treaties. ... Technically, it [a Greek

exit] can be managed. … It is not necessarily fatal, but it is not attractive.” Patrick Honohan, Governor of the Central bank of Ireland [May 2012]

• “The consequences for Greece [of a eurozone exit] would be more serious than for the rest of the eurozone.” Jen Weidmann, President of the Bundesbank [May 2012]

If a (partial)‘break-up’ is Inconceivable, Then What?

• A ‘quantum leap’ is needed in developing and maintaining a sound framework for governance– Rethinking role of ECB– Rethinking the possibility of default, exit & expulsion– Rethinking enforcement of fiscal policy performance– Override provisions in MP , fiscal policy, & a debt strategy

• But this requires the ‘thinking slow’ option; the ‘thinking fast’ option is a break-up

Fast & Slow Thinking About €

• Fast thinking = continued austerity, threats against those who want to weaken fiscal compact, maintenance of existing MP strategy

• Slow thinking = recognition that imminent € area collapse requires ‘adjustments’– “Jens Ulbrich, head of the Bundesbank’s economics department, told the

finance committee of the German parliament that Germany is likely to have inflation rates “somewhat above the average within the European monetary union” in the future and that the country might have to tolerate higher inflation for the sake of rebalancing within the euro zone.” May 11, 2012

75

80

85

90

95

100

105

110

115

2000 2002 2004 2006 2008 2010

Germany Greece IrelandItaly Portugal Spain

IMF

def'n

real

eff

ectic

e de

prec

iatio

n (2

005=

100)

Uni

t lab

or c

osts

REAL EXCHANGE RATE

A POST – EMU PHENOMENON?

“I am especially wary of analysis that shows a divergence of unit labour costs, or other national price indices, since 1999 when the euro was introduced. Germany entered the eurozone with an overvalued exchange rate, which has exaggerated the extent of the subsequent adjustment made by Germany compared with others.” Münchau FT “The Only Way to Stop a Eurozone Bank Run”, 21 May 2012

SOURCE: De Grauwe (2012),CEPS Policy bBief 268

-6

-4

-2

0

2

4

6

2000 2002 2004 2006 2008 2010

euro area Germany GreeceIreland Italy PortugalSpain

HIC

P in

flatio

n (%

cha

nge

annu

al)

INFLATION RATES

Source: Author’s calculationsusing IFS CPI data

Euro-zone in Balance Sheet Recession: Euro-zone Private Sector Increased Savings Massively after the Bubble

-8

-6

-4

-2

0

2

4

6

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Rest of the World

(as a ratio to nominal GDP, %)

Households

(Financial Surplus)

(Financial Deficit)

Corporate Sector(Non-Financial Sector + Financial Sector)

General Government

Note: For the latest f igures, 4 quarter averages ending with 3Q/11' are used.Source: ECB

Financial Surplus or Deficit by Sector

Shift from 3Q 2008 in

private sector:3.66% of GDP

Corporate: 3.12%Households: 0.54%

Shift from 3Q 2008 in

public sector:3.12% of GDP

Source: Koo (2012)http://ineteconomics.org/conference/berlin/world-balance-sheet-recession-what-post-2008-west-can-learn-japan-1990-2005

Money Growth (M3) in the € Zone

More QEplease?

Source: ECB Statistical Data Warehousehttp://sdw.ecb.europa.eu/home.do?chart=t1.2

Lessons from Canada?

• # 1: fiscal & monetary policies must work together• # 2: Monetary objectives/strategies need to be

reviewed/renewed regularly– To ensure democratic accountability– In recognition that the world is dynamic not static as

Treaties tend to assume

Conclusions I

• “It can’t Happen, It’s a Bad Idea, It Won’t Work”– Another ‘black swan’?– “…the standard scenario for an EMU collapse has been discussed so many

times that it sometimes seems to long term eurobuffs like myself as it had already happened” (Krugman 1998)

– “… there is a very wide gap between what the euro needs to survive and what European leaders are willing to do, or even talk about doing. And given that gap, it’s hard to find reasons for optimism.” (Krugman, 26 Sept 2011)

• They were wrong then, could they be wrong again?– “... this colossal error of a single currency.” JOHNSON & BOONE, May 27, 2012

Conclusions II

• The euro will survive– If politics come first: the Southern & Eastern flanks

needs thinking about in political terms– If some of the economics are met: some

mutualization of euro area debt, ECB’s role, some fiscal coordination