1. 16. EMU: ECONOMIC AND MONETARY UNION 1. Why EMU, such a unique experiment? 2. The institutional setup of EMU 3. EMU: the first decade (when all wen well, or we thought so, not realizing that imbalances and bubbles were being built up) 4. EMU: the second decade (when all went to hell or at least towards an exceptionally deep and multidimensional crisis) 5. Policy action in the crisis 6. EMU: the issue of institutional reform 1

2. EMU: the economic arguments  microeconomic benefits in terms of efficiency: less exchange rate risk and transaction costs, more price transparency and better competitition, the euro might become a global currency comparable to the dollar (with associated seignorage benefits and possibility to borrow in your own currency)… versus  macroeconomic risks in terms of stability: lack of adjustment mechanis when giving up the currency and the exchange rate, lack of monetary policy of your own with risk of being hit by ’asymmetric shocks’ such that one and the same monetary policy cannot be good for everyone (’one size fits all’ ain’t good). The case for EMU was far from overwhelming according to the the view of many or probabyl most economists, so Why this bold, risky, historically unique, surprising JUMP INTO THE UNKNOWN? 2

3. 1. The EMU: genesis  The long-standing attachment to exchange rate stability - the gold standard - the Bretton Woods-regime - European exchange rate cooperation (EMS) - the problems the EMS run into; cf. the ’impossible trinity’ - the ’credibility doctrine’ of monetary policy: admiration of the idea of an independent and anti- inflationary central bank and notably the ’Buba’ (the German Bundesbank)  Politics and EMU: the road to Maastricht - the legact of WWII - the dream of ’ever closer union’ - German reunification 3

4. The impossible trinity (pick 2 out of 3) 4

5. Dresden 1944 5

6. Politics and EMU: the road to Maastricht  A group chaired by the prime minister of Luxembourg, Pierre Werner, presented a plan for setting up an economic and monetary union in 1970; this plan foresaw a need for a political union - but did not spell out how to achieve it. Subsequent exchange rate turbulence led to the burial of the Werner plan.  In the late 1970s, German chancellor Helmut Schmidt and French president Giscard d’Estaing saw EMU as a way of strenthening price stability as well as European unity and as a way to ”escape German domination”  French president Francois Mitterand foresaw German reunification already in the late 1980s and started to ponder its implications; he wanted Germany to share its monetary policy in exchange for security guarantees  He later agreed with German chancellor Helmut Kohl that Germany would give up the D-mark through setting up the EMU with a view to deepening European integration (arguably necessitated by German reunification)  In 1988 they set up a committee of experts (central bankers), chaired by the legendary president of the Commission Jacques Delors, to prepare EMU 6

7. (cont.)  The committee made wide-ranging proposals and stressed the need for ”parallel advancement in economic and monetary integration” (factor mobility, wage and price flexibility…) without directly recommending a changeover to EMU  There was not a formal bargain of Germany signing up to EMU and giving up the D- mark in exchange for reunification, but the former would have been unlikely to happen without the former: France wanted the EMU, Germany was hesitant  Mitterand pointed out to Kohl that, lacking serious negotiations on EMU, Germany risked facing a triple alliance of France, UK and the Sovjet Union, which could lead to German isolation  The Maastricht treaty, agreed in 1991, set a timetable for EMU by 1999 at latest and the main requirements, including the convergence criteria to be fulfilled in order to qualify (low inflation, low long term interest rates, a stable exchange rate, below 3 % of GDP budget deficit and below 60 % of GDP public debt)  NB: The Maastrich treaty was agreed despite strong misgivings by the Bundesbank 7

8. (cont.)  The numbers were arbitrary: 3 % because of French figures for 1993, 60 % because that would be compatible with 3 % deficit and 5 % nominal GDP growth(!)  Why was the debt criterion later disregarded in deciding on membership? Because LUX was ok and was in a monetary union with BEL (which had a debt ratio of 120 % but had to get in so as not to break LUX-BEL apart); thus, ITA also escaped the requirement to fulfill the debt criterion; what was meant to be a union around the ”hard core” (FRA+GER+Benelux) became large and heterogenous (politics)  The final preparations started in 1995 with the specification of a reference scenario for the changeover to the euro and by agreeing that the name should be ”euro” instead of ”ecu”  For Kohl, EMU was ”a matter of war and peace”, for his successor, Gerhard Schröder, it was a ”premature sickly child” 8

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11. 2. EMU: the institutional set-up  The European Central Bank (ECB), modeled upon the ”Buba” (Bundesbank)  The eurogroup (agreed in 1997), as a forum for policy coordination (or, for the French, as a ”gouvernement économique”)  Fiscal rules: the Excessive Deficit Procedure (EDP), meant to prevent ”excessive” (above 3 % of GDP) general government financial deficits, and the Stability and Growth Pact (SGP), meant to complement the EDP by requiring member states to aim at overall balance or surplus in their public finances in the medium run  NB: decisions on the EDP are taken by qualified majority and can involve sanctions if corrective action is not taken (at least in principle, in practice it has not happened so far)  A general obligation to economic policy coordination (the broad guidelines of economic policy, a Community act giving overall and country-specific recommednations on economic policies (no sanctions though) 11

12. (cont.)  No central bank financing of governments is allowed, interpreted to mean that the ECB nor national CBs must not buy government paper in the primary market; many consider that the ECB has violated this rule in recent years  No privileged access of public bodies to financial institutions  No bailout of member states in financial difficulties by other member states or by Community institutions; arguably this rule has been violated by the financial packages created since 2010 to avoid sovereign default  NB: The purpose of all these rules is to ensure ”sound” public finances, that EMU does not strengthen the deficit bias in public finances  NB: the purpose is also to ensure that each member state faces up to its responsibilities, that debts cannot be ”mutualized”, that governments pay the rate of interest demanded by market conditoins (or they default)  At least implicitly the EMU is based on an economic policy doctrine that assumes that all is fine as long as the central bank is independent and anti-inflationary in its policies and all member states keep their budgets in reasonable balance (price stability and budget discipline). This Maastricht- doctrine did not pass the test once the financial crisis erupted. 12

13. The European Central Bank  The ECB and the national central banks (NCBs) of the euro area countries together make up the Eurosystem;  The main tasks of the ECB is to formulate and implement the monetary policy of the euro area. Other tasks include: - the conduct of foreign exchange operatioins - the holding and management of official foreign exchange reserves - promotion of the smooth operation of the payments system - authorisation of the issuance of banknotes in the euro area - to contribute to prudential supervision of credit institutions and the maintenance of financial stability  NB: ”the primary objective of the ECB shall be to maintain price stability” (the treaty); it may support other policy objectives only if this does not undermine the primary objective (”lexiographic” target function)  NB: The ECB is goal independent: it is the ECB itself which has defind the price stability objective as a rate of inflation in the medium term below but close to 2 % (a target that it has not achieved for some time as inflation has been close to zero or even negative = deflation)  NB: The ECB is operating a two-pillar monetary framework, focussing on expected price developments but also considering the rate of growth of the stock of money 13

14. (cont.)  The ECB is exceptionally independent: the members of the Executive Board (six members) and the NCB governors (now 18), which together make up the decision-making body, the Governing Council, are frobidden to seek or take instructions from governments and Community institutions.  Also, the members of the Governing Council have long and non- renewable terms of office and the NBCs and the ECB are financially independent.  The ECB is accountable to the European Parliament (reporting obligation)  Monetary operations of the ECB are partly implemented by the NBCs but under strict guidance from Frankfurt 14

15. Summary and final comments on the genesis of the EMU  European citizens and decision makers have always had a strong preference for exchange rate stability, be it in the form of the gold standard, the Bretton Woods-regime or European exchange rate cooperation  European exchange rate cooperation turned out to be vulnerable to differences in national circumstances and policies and often led to currency speculation and turbulence  It was gradually realized that the impossible trinity necessitates giving up monetary autonomy if fixed exchange rates are to be compatible with free capital flows  EMU has been seen as one further step towards deeper political integration, and the fall of the Berlin Wall was the triggering point (geopolitics )  The euro area became large and heterogenous, also a consequence of political considerations  The institutional basis of the EMU is thin, this is a consequence of the great difference between German and French views: - Germany: ”Stabilitetsgemeinschaft”, binding rules, sanctions (preferrably automatic) versus - France: ”gouvernement économique”, discretionary decision-making  Also opposite views on the desirability of CB-independence (key for Germany, nuisance for France)  The euro is a currency without a state, an asymmetric construction. It is conceived of as a rule-based system, where the only body making discretionary decisions for the area as a whole would normally be the ECB 15

16. 3. EMU: the first decade (when all went well or seemed to do so – but imbalances were building up )  Joining the EMU brought with it significantly lower interest rates for a number of member states (GRE, POR, IRE, SPA, ITA, also FIN) – why? (good question: exchange rate risk disappeared and inflation risk was reduced but default risk actually was magnified, as was later realized)  The rapid convergence of nominal interest rates, including bond yields on long-term government bonds, had the consequence that real interest rates were lower the higher the rate of inflation (which is kind of perverse)  Low real interest rates have been associated with rapid credit expansion  Rapid credit expansion has been associated with big increases in house prices (implying a risk of a bubble)  Low real interest rates and rapid credit expansion have also been associated with a large cumulative increase in real growth of domestic demand 16

17. Interes rates on government bonds Finland Greece Germany Irland 1995200020052010 Italy Spain 17

18. Real rate of interest and inflation 1999-2008 Inflation = average consumer price inflation Real interest rate = 10 year government bond yield less inflation as defined above 18 Finland France Germany Austria Italy Irland Netherlands Portugal Belgium Denmark Inflation Real interest rate Greece Spain Real interest rates were higher the lower the rate of inflation and vice versa – presumably the opposite to what would have been called for!

19. Real rate of interest and credit expansion 1999-2008 real rate of interest = 10 year government bond yield less consumer price inflation credit expansion = average increase in stock of outstanding bank loans 19 Finland France germany Austria Italy Irland Netherlands Portugal Belgium Greece Spain Real rate of interest Credit expansion Low real interest rates go hand in hand with rapid credit expansion

20. Credit expansion and housing prices 1999-2008 credit expansion = average increase in stock of bank lending housing prices = cumulative increase in housing prices 20 Finland France Germany Austria Italy Irland Netherlands Portugal Belgium Greece Spain Credit expansion Housing prices Rapid credit expansion tends to go hand in hand with rapidly rising house prices.

21. Credit expansion and domestic demand 1999-2008 credit expansion = avergae increase in stock of bank loans domestic demand = average annual growth of domestic demand 21 Finland France Germany Austria Italy Spain Netherlands Portugal Belgium Irland Credit expansion Domestic demand Greece Rapid credit expansion also fuelles a rapid rate of growth of domestic demand (private consumption plus investment).

22. Unit labor cost 1998-2008 unit labor cost of the whole economy, index, 1998 = 100 22 Finland Greece Germany Irland Italy Spain Portugal France Rapid growth was associated with rapidly rising unit labor costs

23. Competitiveness and the current account (% of GDP), changes from 1998 to 2008 There is a reasonably clear association of external balance (the current account) and competitiveness (relative unit labour costs in a common currency) 23

24. Summary of the preceding  Nominal interest rates declined significantly in Southern Europe upon joining the EMU, but inflation remained higher than elsewhere, so real interest rates were comparatively low  Low real interest rates were associated with rapid credit expansion, rapid increases in house prices and rapid growth of domestic demand  Rapid growth of domestic demand was assoicated with relatively high wage and cost increases leading to increases in relative unit labour costs  Loss of competitiveness showed up in weaker exports and notably in a negative development of the current account; the deficit on the current account increased significantly in all those countries that later have come to be identified as the crisis countries  The loss of competitiveness gradually also undermined growth and employment 24

25. 4. EMU: the road to the crisis  The global financial crisis acted as a trigger, default risks for both banks and sovereigns were suddenly perceived to be much greater than before  Interest rates rose because of higher risk premia, in certain cases dramatically, so the bubble burst and asset prices as well as domestic demand started to fall  Competitiveness problems for crisis countries: need for lower wages  Monetary policy, arguably not loose enough  Fiscal policy after 2009 tight, particularly so in the crisis countires: austerity reduces growth and increases unemployment, in some cases to dramatic levels 25

26. Crisis: a typical pattern Rapid credit expansion, rising asset (e.g. real estate) prices, euforia Bad news, bubble bursts, credit losses, fear takes hold BANKING CRISIS Credit crunch, deep recession, falling tax revenues, bank support PUBLIC DEBT CRISIS 26

27. Housing prices 1999-2013’ index, 1999/1 = 100 27 Finland Greece germany Irland Italy Spain Portugal 19992002201120052008 What goes up may also come down

28. Private consumption (volume) in selected EA-countries, 2007=100 28

29. Unemployment rates in selected EA-countries (% of labour force) 29

30. Taulukko 1 Economic developments in PIIGS- and FANG-countries Sixten Korkman: EURO – Valuutta vailla valtiota.Lähteet: OECD, Eurostat, AMECO, NIESR, ETLA. 1. Real interest rate 2. Credit expansion 3. Housing prices 4. Domestic demand 5. Unit labor costs 6. Current account 7. Budget balance 8. GDP growth 9. Unemployment rate 1.5 295.6 109.1 2.4 34.0 -5.4 -2.4 3.1 8.0 5.6 -4.1 -19.9 -2.7 -3.9 -3.1 -8.8 -2.0 15.4 2.4 96.8 52.9 1.8 13.6 3.9 -0.1 2.4 6.4 0.7 9.0 11.6 0.0 12.0 4.0 -2.9 0.0 5.9 1999-20082009-20131999-20082009-2013 PIIGS-ciesFANG-cies

31. Aspects of the crisis  The global financial crisis led to a reconsideration of risks, which gradually increased risk premia for government bonds issued by the PIIGS, in some cases dramatically; the interbank market was quite strained in certain periods (late 2008 and again in late 2011)  Countries with high real interest rates experienced sharp declines in house prices and in overall domestic demand, private consumption and investment  Weak demand was gradually associated with improved competitiveness, better exports (to some extent) and notably improvements in the current account  The development since 2008-2009 has been largely the reverse of developments in 1999-2008: what goes up, comes down (boom-bust cycle and now a banking crisis, a sovereign debt crisis and large current account imbalances) 31

32. 5. Policy actions to combat the crisis  Financial support mechanisms and packages (Greece, Portugal, Ireland, Spain, Cyprus)  Adjustment policies in crisis countries: structural reform and ’austerity’, that is budgetary tightning = spending cuts and tax increases  Debt restructurings (Greece and Cyprus mainly)  Fiscal rules and their governance sharpened (to promote budget discipline)  Economic policy coordination? (not really in practice)  Economic policies of triple A countries (arguably too tight notably in Germany)  Actions by the ECB (arguabyl ’too little too late’, not sufficiently expansionary) 32

33. Management of the current crisis: another trinity Debt restructurings Adjustment Co-financing (ESM/ECB) NB: All three needed + appropriate balance: less adjustment, more financing (with conditionality) and more debt restructuring (e.g. Greece, Spanish, Cypriotic banks) AND maximally expansionary ECB policy (+ less austerity in the North) 33

34. Austerity and cumulative GDP growth in 2009-2012 (austerity = change in cyclically adjusted budget balance, the bigger that change the tighter is fiscal policy ) GRE IRE Austerity is bad for growth, at least in the time span here considered 34

35. EMU: risks that were neglected when setting up EMU Banking and financial stability: the problem of high leverage Assume that the economy has been developing favourably for a number of years, that confidence is high and risk premia and interest rates are low. The balance sheet of the representative investor is A = K + L,A = total assets, K = equity, L = debt The return on equity of the portfolio is r E = (r A A - r L L)/K = (r A (K + L) - r L L)/K = r A + (r A – r L )(L/K), where r E is the return on equity, r A the return on total assets, r L the rate on interest on debt and L/K the degree of leverage. Obviously, with optimistic expectations w.r.t. the return on investment and/or a low rate of interest on debt, the expected return on equity can be improved by increasing leverage. However, this is at the expense of higher risk or a higher variance of the rate of return: V(r E ) = (1 + (L/K)) 2 V(r A ) with V denoting variance (assuming no uncertainty for the interest rate. Obviously, the risk or variance of the return is an increasing function of the degree of leverage. 35

36. Banking and financial stability: spillovers The (highly) simplified balance sheet of a representative bank can be written as L + B = D + R + K where L is the stock of outstanding loans, B denotes other investments by the bank (in, e.g., bonds), D stands for deposits (or funds raise in the money market), R is debt to the central bank (negative if the bank holds positive reserves in the CB), and K is equity capital. The bank typivally has a very high degree of leverage and it may end up in difficulties if, e.g., - it is hit by credit losses on outstanding loans as a consequence of, say, having financed real estate speculation associated with a housing price bubble (and with high leverage also for borrowers) - it is hit by capital losses on its holdings of other assets such as domestic or government bonds (as a consequence of rising interest rates and therefore lower valuations of the bonds held) - it is hit by deposit flight, as deposits are typically of short maturity as compared to bank lending (banks are in the business of ”maturity transformation”). The last is a liquidity problem and can normally be resolved by borrowing from the CB. However, the first two problems concern solvency, they may bring equity to a dangerously low level or make it negative. Of course, bank regulation and supervision try to ensure that banks do not lend recklessy, that they hold enough equity relative to risks incurred (capital ratios) and that they do not use deposits to finance speculative holdings of risky assets. Problems of banks may have ”contagion” effects on other banks, and there may be interactions of sovereign (government debt) and bank problems. 36

37. Banking and financial stability: spillovers (lethal) Country 1 Country 2 Bank problems spill over to the government because the soverign may not want to allow the bank to fail and is its ultimate source of security, often willing to bail out banks in trouble. Government problems spill over to banks because funding problems of the government weaken the implicit guarantee of the banks, and because rising interest rates (lower prices) of government bonds may inflict capital losses on banks. Government problems may also spill over to banks in other countries if they hold bonds issued by problem countries in their portfolios. Finally, in an integrated banking system banks hold claims on banks not only in their home country but also on banks in other countires: more spillover potential. Government Banks 37

38. EMU: risks that were neglected when setting it up Sustainability of public finances There are reasons for which the cumulative effect of government budget deficits may cumulate so as to create a situation which is unsustainable: the government risks defaulting on its outstanding commitmens (its debt). Conceivable reasons for such a situation to emerge include A deficit bias in public finances: decision makers prefer (becuase of myopia, or the influence of lobbyist or sheer political opportunism) spending and/or tax reductions now at the expense of incurring debt, which becomes a burden on young or new generations The country may suffer from a deep and long recession, which reduces tax revenues and increases spending for the unemployed The country may face the consequences of demographic change, in the form of aging populations, which increase age-related public spending The country may be hit by a banking crisis, which forces the government to bail out large parts of the banking system Historically the most common reason for public sector financing difficulties have been the consequences of war, but also banking crises have often led to large increases in public debt 38

39. NB that it can be very difficult to break a spiral of increasing indebtedness if there is great political resistance to cutting expenditure, if it is difficult to raise (or to collect) taxes, if the interest rate paid on government debt is high, if growth of the economy is weak or negative and if the debt level is high. 39

40. (cont.) The government may face borrowing difficulties if the assessment of the market is that the present value of future tax revenues is not enough to finance future spendings, including spending to service and repay outstanding loans. The above equation helps to see the ways in which the government may hope to ameliorate the situation : It may improve the primary balance by cutting (non-interest) expenditure or by raising taxes, but that may be politically very unpopular or administratively difficult and the short-term effects on the economy are likely to be negative It may try to achieve stronger growth, but how? It can generate higher inflation, which would increase nominal GDP growth, and hope that this would not be reflected in a higher nominal rate of interest, but given the exchange rate this will presumably hurt competitiveness and growth It can try to reduce the level of indebtedness by selling property (privatization) or by negotiating a voluntory write-down of debt with creditors NB: government debt feeds itself (unless the rate of interest is lower than the rate of growth of the economy), which means that the process is unstable unless stabilized by policies operating on the primary balance. 40

41. Action to contain the crisis Easing the pain – or just prolonging it? Adjustment Debt write-downs must Given conditionality,be seen as an option (but financing should be then large and quick if…) arranged as needed Financing Debt restructuring Wage rises in triple-A countries would help – as would bolder ECB-action! Sufficient time for fiscal adjustment is needed, but progress on structural reform to be insisted upon 41

42. 6. EMU: the issue of institutional reform  The fiscal rules have been rewritten with a view to tightening budget discipline, but implementation has been lax (more time given to France recently – again)  Macroprudential supervision has been introduced  Work on setting up a banking union has been intitiated, is going on  EMU needs a ’fiscal union’?  EMU needs, in the end, to develop into a fully-fledged ’political union’? 42

43. Banking union: building blocks + lender of last resort (ECB) to prevent runs on banks (if solvent) + ex ante levies on banks (deposit insurance and resolution fund) + possibly ex post levies if government money has to be used 43 Bank regulation -mainly EU -also national Bank supervision SSM -ECB (also ESRB) -national Bank resolution -national - euro area ?! Deposit insurance -national -euro area? Minimum fiscal backstop (= ESM?) Bank resolution fund -national -euro area

44. 3. Building Blocks of a Banking Union There is no agreed definition of a banking union, but it may include at least the following aspects: A unified framework for regulation and a coherent framework for bank supervision A lender of last resort for banks (a function which the ECB is already de facto fulfilling) An authority with power to undertake resolution of banks in difficulties and equipped with a bank resolution fund to provide financing if need be A coordinated or common deposit insurance system Conceivably a minimum fiscal backstop to provide financing for handling a banking crisis (if the bank resolution fund an central bank lending to banks does not suffice) An appropriate framework of coordination committees and framework for macroprudential supervision The aim of setting up a banking union is to eliminate or alleviate the significance of cross-border spillovers: Distressed banks may cause contagion to banks in other countries (which purely domestic arrangements do not necessarily give sufficient attention to) Banking problems may undermine the credibility of sovereigns, the bonds of which are held also by foreign investors Government debt problems may threaten the banking system and vice versa, a negative feedback mechanism that national authorities may find difficult to break etc. One important source of inspiration for the Banking Union is the USA, where banking is mostly a comptence of the federal authorities. California may be on the verge of bankruptcy, but nobody is concerned about the health of Californian banks or repercussions from California to the rest of the USA via the financial system. The main explanation seems to be the existence of the American banking union. The Commission has proposed steps towards a BU for the euro area with opt-in possibility for others. 44

45. The trilemma and the Banking Union National ”banking policy” Common currencyFinancial and economic (EMU) stability C omment: A common currency goes hand in hand with integrated banking and requires a common framework or ”banking policy”, a banking union. There is also a need for a ”minimum fiscal backstop”, the size and signficance of which can be modest – if regulation and supervision is tight and there is effective PSI (”bail in”). 45

46. 10. Beyond banking union? According to the functionalist view of integration, each step towards deeper integration will necessitate further steps for the system to function satisfactorily. This will end only when a federal state with significant powers, the United States of Europe, has come into being. This view was rather common among the ”founding fathers” (e.g. Jean Monnet), it was one reason why the Bundesbank was agains setting up the euro (they thought political union should precede monetary union), it has been the hope of numerous ”federalist” idealists, it is popular among citizens and politicians in the South (less so in the North), and it is one of the reasons for the strongly negative attitudes of British conservatives. It is the BIG question: Can you have a common currency without a common fiscal policy, tax policy, social policy and political legitimacy based on democratic institutions at the euro area level? If the answer is yes, then we face the problem that such deep integration would need the backing of solidarity across borders. However, it seems that citizens’ identity and solidarity still has a strongly national focus. Thus, it is difficult to provide a federal construction with the needed legitimacy in the eyes of citizens. Proposing to set up a fiscal or political union to resolve the currrent crisis may seem logical but is politically unrealistic and could backfire, as citizens would feel that temprary circumstances are used as a pretext for long- terms institutional solutions that should be evaluated on their own (permanent) merits. 46

47. Fiscal union Banking union will presumably need the support of some sort of a minimum fiscal backstop at the euro area level (given the legal and other restrictions on activity by the ECB). However, this backstop can conceivably (or hopefully) be of rather modest size, thereby limiting the amount of debt mutualization. Also, this backstop would be for a specific and restricted purpose. The idea of the fiscal union is that mutualization should be accepted in a broader and quantitatively much more significant sense. Proposals in this direction can almost always be criticized for causing ’moral hazard’ among political decision makers and/or banks and other lenders. While it is not fully clear what attributes proponents of a fiscal union attribute to it, these would seem to include at least the following: Eurobonds (debt mutualization, ”joint and several” rather than ”pro rata”) This would in its most simple form mean that all euro area member states would borrow with a common debt instrument, a eurobond, for which all member states governments would give a ”joint and several” guarantee, meaning that, in extremis, Finland could be responsible for the whole debt of the euro area (if all other states were unable to pay). The joint and several type of guarantee thus goes much further than guarantees so far used, which are on a pro rata basis (the maximum responsibility of Finland is a bit less than 2 % of the total). In its simplest form, the eurobond would seem to imply considerable implicit transfers form well-behaved countries to countries with difficulties in debt markets: all borrowing would be at the same interest rate, implying an increase in the interest rate for government bonds for countries like Finland and a decrease for countries like Greece. 47

48. (cont.) One advantage of the eurobonds would be that they would provide the ECB with convenient material for open market operations and as collateral for borrowing by banks (doing away with the need to use bonds issues by member state governments). Budget discipline Proponents of the fiscal union suggest that the counterpart to the eurobonds would be a tightening of budget discipline, notably by giving the union level authorities (the Commission and/or the Council) much stronger authority to decide over national budgetary (and conceivably other) policies. There have already been some moves in this direction through the tightening of fiscal rules and the new fiscal compact. However, legally it would seem quite difficult for member states to give up their national sovereignty over the budget without entering into conflict with the treaty and/or national constitutional laws. Also, politically it is difficult to see how the fiscal union could operate. The government of a particular country can always commit itself to any action decided upon in Brussels, but then citizens may decide to vote the government out of office. What do you do if governments are unable politically to implement the orders given by union level authorities? (Send tanks to Rome or Athens? Whose tanks?) Fiscal capacity Another proposal, independently of the two others, is to provide the monetary union level with some fiscal capacity in the sense of allowing deficit spending by the union level authorities wuch as the Commission. (Deficit spending at the unin level is currently not possible; the EU budget must in principle be in balance annually.) Alternatively, one might introduce an automatic or quasi- automatic mechanism for helping member states to meet cyclical fluctuations. For instance, it has been proposed that unemployment benefits would be partially financed at the union level: thus, countries experiencing rising unemployment would receive transfers from countries with more favourable developmentys. In principle this could function as a macroeconomic insurance mechanism. In practice, however, it could amount to a semipermanent transfer mechanism to countries with dysfunctional labour markets. The Commission has recently proposed to offer financial support to countries undertaking structural reforms deemed to be beneficial in the long term but difficult in the short term. However, the proposed magnitudes are quite modest. 48

49. Political union It is not clear what the concept of political union would should mean. Presumably it would include both a banking union and a fiscal union. Conceivably, it would also mean harmonized taxes, or a common tax system, and a common framework for social policies, perhaps a (partly) common police force and army. The main point is that it would include specific mechanisms for creating political legitimacy at the federal level. Thus, the highest political authority would be a union level parliament with extensive powers. Also, there would need to be a union level government propsing legislation and being responsible for executive decision making. Similarly, there would be a need for some consitutional court for the federation. It is difficult to imagine a political union without common parties on a cross-border basis and without a common area for political debate (including media with cross-border coverage). However, such developments run into barriers associated with language and customs that are conditional on idiosynratic conditions and historical developments. Given the national orientation of identity and solidarity, the dominating role of the nation state cannot be denied (wether considered good or bad). Therefore, if political union is indeed a precondition for the monetary union to function, then the conclusion would be that EMU is doomed to fail. 49

50. The future of EMU: why not fiscal/political union?  debt mutualization/joint responsibility creates moral hazard, is poisonous  nevertheless, debt mutualization is acceptable in 1) a serious crisis (like this one), 2) for specific purposes and/or in limited amounts (cf. EMS, ECB too?) and also in 3) genuine insurance systems (such as a well-run banking union)  it has to be recognized (even though it may be regretted) that solidarity between citizens of different member states is rather limited AND member states are not willing to give up budgetary sovereignty (except when in serous distress); debt mutualization (eurobonds) in conjunction with centralized fiscal powers is consequently a non-starter  the key to an improved fiscal performance is better rules and stronger fiscal institutions of member states (as recognized in the ”fiscal compact”)  Nota bene that serious steps towards fiscal union would require changes to the treaty and (in many cases) national constitutions! 50

51. EMU: Quo vadis? The euro area got into difficulties in the autumn of 2008 as a consequence of the global financial crisis, which was first interpreted as a purely American ”subprime mortgage” crisis. Only as from early 2010 was it becoming obvious that the euro area would be a main arena for the financial crisis. Three years later the crisis has spread from Greece to many other countries (the GIIPS) and its effects are felt all over Europe (and beyond). Available forecasts do not suggest any rapid resolution of the crisis: -output is still weak and unemployment high even if not rising anymore in most crisis countries; -balance sheets of banks are still weak and many banks around Europe are vulnerable; -government deficits have been reduced but debt levels relative to GDP are high or rising; -there is an aspiration to set up a banking union but it will not be set up with such a speed as to help solve the current crisis; -debate continues about the proper balance between adjustment (the austerity debate), financing (by the ESM or via the ECB?) and private sector involvment or debt restructuring (with concern about deposit or capital flight being triggered in countries at risk); -there is no ”magical bullet” for such a multidimensional crisis as this: government debt crisis, banking crisis, macroeconomic crisis, current account crisis, cost crisis, governance crisis, political crisis. -The current hope is that quantitative easing by the ECB in combination with the fall in oil prices will help Europe turn the corner and resume growth Conceivable scenarios for the euro area development include: - the ’main scenario’: a prolonged ”muddling through”, followed, in the end, by a more robust development as structural reforms are improving growth prospects in crisis countries - exit of some minor countries (such as Greece) without the EMU as a whole being threatened - the strong countries leaving the euro, which becomes a weak currency (so far higly unlikely) - the weak countries exiting the euro, defaulting and causing a Europe-wide banking crisis and depression (an economic and a political catastrophy). 51

52. The exit issue The conceivable consequences of an exit would obviously depend on which country exits and under what circumstances. Thus: Grexit An exit of Greece has at times and by many observers been seen as a likely scenario, but it has not happened (mainly because nobody wants to take the decision?). Grexit would imply, inter alia: - a prolonged banking holiday, capital controls, restrictions on taking out deposits from banks - introduction of a new drakhma, followed by a huge depreciation and rapid inflation - conversion of deposits and assets/liabilities from euro into the new drakhma whenever this is legally possible (that is, for assets under Greek law) - moratorium on most debt service, because much of the debt is denominated in the euro and cannot be redenominated legally (implying a huge rise in the value of debt in drakhma terms) - sharp fall in consumption and bankruptcies of many ordinary businesses due to the difficulties of setting up a new payments system (and even get notes and coins in circulation). For the euro area as a whole, Grexit need not have significant consequences unless there were contagion to other weak countries due to the fact that the ”irreversibility” of the euro would be demonstrated to be a myth. Exit of several weak countries (Club Med exit) This could be triggered by Grexit, notably if it would seem succesful in restoring competitiveness and reducing the burden of debt service (moratorium). Consequences: - same sort of banking holiday and similar economic consequences and legal difficulties as above (numerous law cases with fights about what redenomination is acceptable) - the default triggered by exit (making debt service impossible) would lead to a collapse of the banking system in Europe and would thereby cause a Europe-wide depression - NB: the effects would be quite similar all over Europe, including in Sweden (given the importance of banking in Sweden). 52

53. (cont.) How about Fixit? Exiting the euro is not attractive for Finland because:  The transitional costs of setting up a new payments system would be LARGE and the changeover process chaotic  The legal problems of redenomination are considerable  It would give no protection against the main risk: a collapse of the euro  It would not significantly reduce Finnish commitments (certainly not those already entered into)  The TARGET of the Bank of Finland in the ECB balance is positive (money lost?)  The geopolitical status of Finland would suffer seriously A split between North and Souht Heterogeneity of the euro area is the problem. A split into at least two might seem the solution. However, exit by the South would cause defaults and chaos. Exit by the North might be easier: Northern Europe could start by introducing a virtual parallel currency (the ”hard” euro). Contracts could be gradually redenominated into this new currency, which could in due time also exist as notes and coins. The present and henceforth ”weak” euro would depreciate relative to the hard euro, but this would not affect the debt burden of the countries remaining with the weak euro (as their assets and debts would largely remain denominated in the same currency). Technically such a split might be conceivable, politically is would presumably be perceived as a failure of ”Europe”. But the point is that the Northern countries have a bargaining chip in the sense of a viable alternative and cannot therefore be pressured by the Southern countries too much against what is the political will in the North and notably Germany. The enviseaged split would be problematic for Finland: join the soft South or the hard North (and risk facing consequences of a strong currency at the wrong time)? 53

54. The future of EMU: bottom line  muddling through continues towards recovery, possibly interrupted by social or political developments triggering anew an acute crisis  at the end of the road there is a Maastricht union with reinforced rules and supplemented by a banking union, the essential task of which is to allow the no bailout-rule to be respected. Hopefully this will work; otherwise EMU will become one more case in the graveyard of failed monetary regimes  EMU has been neither a success or a total failure (what is the counterfactual?) but as set up it did now work well, and for the crisis countries it has been more of a curse than a blessing  However, there is a significant potential upside if the crisis triggers significant structural reforms (cf. the depressions in Finland and Sweden in the early 1990s, which paved the way for favorable developments)  But: Finland has recently been hard hit (Nokia collapse + paper industry) 54

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56. The past of EMU: what went wrong?  weak institutional basis (due notably to Franco-German differences of view) associated with design flaws: no operationalization of the no bailout-rule, no effective framework for fiscal discipline, no banking union, no lender of last resort  some risks were not on the radar screen: notably the risks of government default and of excessive private borrowing & banking crisis  member states failed to undertake reform and pursued irresponsible economic policies (to varying degrees)  heterogeneity: it would have been better to start by the ”hard core” (Germany + Austria + BeNeLux) 56

57. EMU: What are the lessons?  It has been an essentially political project based on insufficient economic analysis  The ’Maastricht doctrine’ seems to have been that the union only needs an independent anti-inflationary central bank and budget discipline in member states, and then the economy will take care of itself without running into problems!  But budget discipline did not materialize: the budget rules were not respected and the no bailout-rule was not credible (and has also been violated)  It was not understood that a monetary union will enhance financial integration in a way which calls for a banking union  It was not realized that there will be a serious default risk of individual governments once they do not have access to the ’printing press’ (a central bank of their own acting as a ’lender of last resort’)  It is unlclear why authorities expected wage formation and the adjustment capacity to improve thanks to the euro (which did not happen)  It was a serious political mistake to make the monetary union so large and heterogenous from the beguinning  There are still different views on what EMU should look like institutionally (Maastricht + banking union or fiscal + political union) but whatever view one takes, the institutional base was flawed and needs complementary action 57