much ado about emu
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Much Ado about EMU. Andrew K. Rose Berkeley, Haas. Beware Greeks Bearing Bonds. Sovereign default was inevitable So far voluntary; “disorderly” to come? Current Greek 10-yr bond >30% German ≈2% (US, UK, Japan too) Government Debt unsustainable (≈150% GDP) German ≈ 80% - PowerPoint PPT PresentationTRANSCRIPT
Much Ado about EMU
Andrew K. RoseBerkeley, Haas
1Andrew Rose , EMU
Beware Greeks Bearing Bonds
• Sovereign default was inevitable– So far voluntary; “disorderly” to come?
• Current Greek 10-yr bond >30% – German ≈2% (US, UK, Japan too)
• Government Debt unsustainable (≈150% GDP)– German ≈ 80%
• Big government deficits (≈10% GDP) imply continuing deterioration– German ≈ 1%
Andrew Rose, EMU 2
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
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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, starts 7/2012, fully ready by 2014 (!)
– Probably still too small (German objections; France + others wanted €1 tn– EFSF + ESM limit is €700 bn
• European Monetary Fund (EMF) starts July 2012
Andrew Rose, EMU 4
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
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Convergence Criteria, 1
Institutions– Central bank independence– Easy!
6Andrew Rose, EMU
Convergence Criteria, 2
Inflation– CPI inflation within 1.5% of target– Target is average inflation of three countries with
lowest inflation– Still easy!
7Andrew Rose, EMU
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!
8Andrew Rose, EMU
Convergence Criteria, 4
Exchange Rates– Fixed Exchange Rates within “normal bounds”
(15%!)– No realignment within last two years– Once more: easy!
9Andrew Rose, EMU
Convergence Criteria, 5
Fiscal Positions•Members must have “Sustainable Government Financial Position” defined as:
a) Flow: Deficit/GDP ratio of less than 3%, andb) 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
10Andrew Rose, EMU
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
11Andrew Rose, EMU
Hence More Fiscal Austerity
• Considerable pressure on Greece to raise taxes, cut spending (and exacerbate 4-yr recession)– Portugal, Spain, Ireland too– German View: Roasting the Meat (or Burning it?)
• But … will this work?– The markets don’t think so– Most commentators agree with markets
• Right way to approach the problem?
Andrew Rose, EMU 12
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?”
13Andrew Rose, EMU
“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
14Andrew Rose, EMU
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
15Andrew Rose, EMU
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)
16Andrew Rose, EMU
An Alternative Adjustment Method
• Factor Mobility
– Unemployed workers move to places of high
demand
– Relieves unemployment and inflation
17Andrew Rose, EMU
Mundell’s “Optimum Currency Area”
1. Suppose business cycles are asymmetric, and2. There is a) little risk-sharing, and b) immobile
labor, then3. 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)
18Andrew Rose, EMU
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”
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Competitiveness within EMU1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Real Effective Exchange Rate (1999=100)
Germany 100.0 93.3 93.3 94.3 99.4 101.1 99.3 98.6 100.5 101.1 101.6 96.8
Greece 100.0 93.4 94.6 97.5 103.9 106.0 106.4 107.4 109.3 112.4 113.8 113.7
Portugal 100.0 97.6 100.0 102.5 107.2 108.5 108.5 109.1 110.8 111.7 110.9 108.6
Current Account Balance (% of GDP)
Germany -1.3 -1.7 0.0 2.0 1.9 4.7 5.0 6.3 7.5 6.3 5.7 5.7
Greece -5.4 -7.8 -7.2 -6.5 -6.6 -5.9 -7.5 -11.2 -14.3 -14.8 -11.0 -10.6
Portugal -8.2 -10.4 -10.3 -8.2 -6.5 -8.4 -10.4 -10.7 -10.1 -12.6 -10.9 -9.9
Andrew Rose, EMU 20
Bottom Line
• Greece has a fiscal problem– But solving it (if possible) won’t restore growth
• Real problem: poor competitiveness limits growth, employment
• No easy solution for that• Hence … more serious crisis inevitable– Could easily be worse than Lehman
Andrew Rose, EMU 21