1. Optimal Currency Areas & Governance: The Challenge of Europe Jeffrey Frankel Harpel Professor, Harvard University 2011 Annual Conference, Bretton Woods NH, April 10

2. The framework of Niels Thygesen’s paper 1970 – The issues according to the original Optimum Currency Area theory – esp. Mundell & McKinnon. 1990 – The issues as they appeared to those drafting the Maastricht Treaty (1991). –esp. the Delors Report (1989) & One Market, One Money (1990). 2010 – The issues as they appear in light of recent developments, –esp. the sovereign debt crisis of the periphery. 2011: Is Europe making the right reforms in governance?

3. 1970 – The issues according to the original OCA theory For the gains of a common currency to be worth the cost of giving up independent national monetary policies, the countries must have: –“Symmetry” (≡ high correlation of shocks) –Labor mobility (across both borders and jobs) –A system of fiscal transfers (countercyclically) –Openness (a high ratio of tradable goods to GDP). The early concerns of many American skeptics: –Europe lacks most of these OCA requirements.

4. 1990 – The issues as they appeared to those drafting the Maastricht Treaty (1991). “…the background had changed remarkably. The implicit advice from the OCA checklist seemed less relevant, partly because it was… [more] likely to evolve favorably after introducing a common currency than before.” Some research seemed to validate this judgment: –Monetary unions boost trade a lot Rose (2000): “One Money, One Market” –=> Cyclical correlation rises in turn Frankel & Rose (1997,98): “Endogeneity of the OCA Criteria” vs. Eichengreen (1992) and Krugman (1993). –Also, labor markets will be forced to become more flexible Roubini…

5. 1991 emphasized new issues instead Prof. Thygesen lists the desire to address $ instability, and some others. I would, rather, point to the heart of the “Maastricht criteria:” ceilings on budget deficit (3%) & debt/GDP (60%). –Fiscal criteria had not appeared anywhere in OCA theory. One might have said, rather, that loss of the national monetary instrument made a free fiscal instrument more important. –Some economists found them incomprehensible. E.g. Buiter, Corsetti & Roubini (1993). Some speculated on what the Germans’ real motivation was. –E.g., a golden fleece.

6. But the motivation for the Maastricht fiscal criteria is clear as for the No Bailout Clause and the Stability & Growth Pact (1997): Skeptical German taxpayers believed that, before the € was done, they would be asked to bail out profligate Mediterranean countries. European elites adopted the fiscal rules to demonstrate that these fears were groundless.

7. After the euro came into existence it became clear that the German taxpayers were right –and the European elites were wrong. E.g., Greece, even on the distorted budget figures it submitted, never satisfied the 3% rule in any single year after joining. The large countries violated the rule too. SGP targets were “met” by overly optimistic forecasts. SGP targets were “met” by overly optimistic forecasts. SGP threats of penalty had zero credibility. Yet each year the ostrich elites stuck their heads deeper & deeper into the sands.

8. 2010 – Lessons from the sovereign debt crisis Thygesen: –Responsibility for financial stability cannot remain exclusively at the national level. –The same for fiscal stability. –I agree. But I do not agree that the official responses have been the right ones. I agree, rather, with Darvas, Pisani-Ferry & Sapir: –Officialdom has been “reactive rather than proactive,” –treating insolvency as illiquidity.

9. Revisions in EMU governance Fiscal rules “will become more explicit and will be monitored more tightly.”… –Weaknesses in the SGP “are now being addressed.” “Structural reforms … will be monitored closely by the EC.” EU-level supervision of financial institutions, & European Systemic Risk Board (ESRB). Permanent European Stability Mechanism (ESM) for crisis bailouts. –“The loans to Greece in May 2010 and to Ireland… [were] regarded as constructive by most critics.”

10. My reaction The ostriches have stuck their heads down in the sand so far that they have popped up on some other planet. There is even less reason now to think the SGP will work than there was the first time around.

11. European elites’ mistakes in managing the Greek debt problem Admission of Greece to the euro in the 1 st place. ECB acceptance of Greek bonds as collateral –despite high debt & deficits. –=> investors charged near-zero spreads, helped by artificial high credit ratings. Failure to send Greece to the IMF in early 2010. Refusal to think about the likely need for restructuring of the debt.

12. Spreads for Greece & other Mediterranean members of € were near zero, from joining until 2008 Council on Foreign Relations

13. Spreads help keep profligate US states in line as we saw in Carl-Ludiwg Holtfrerich’s paper 13 Holtfrerich (2011) Source: W.B. English, „Understanding the costs of sovereign default …,“ p. 269. as used by Holtfrerich (2011) Yield to maturity in %

14. What alternative fiscal reforms, then? taking as given that German taxpayers will not allow a fiscal union now more than ever. Proposal: 1. The SGP should emulate Chile’s successful fiscal institutions (Frankel, 2011 ) : a)Phrase the budget target in structural terms. b)Give responsibility for determining what is structural to an independent professional agency, to avoid forecast bias. 2. Penalty when a country misses its target: a)The ECB then stops accepting its bonds as collateral. b)=> Sovereign spread rises, with true automaticity.

15. EMU Ostrich

16. References by the speaker Over-optimism in Forecasts by Official Budget Agencies and Its ImplicationsOver-optimism in Forecasts by Official Budget Agencies and Its Implications," Feb.2011, written for symposium on Economic Borders of the State in the Oxford Review of Economic Policy. Over-optimism in Forecasts by Official Budget Agencies and Its Implications “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” forthcoming, Fiscal Policy and Macroeconomic Performance, Series on Central Banking Analysis, and Economic Policies, 2011. NBER WP 16945, April 2011. A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by ChileApril A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by ChileApril "Let Greece Go to the IMF," Jeff Frankel’s blog, Feb.11, 2010. Let Greece Go to the IMFLet Greece Go to the IMF “The Estimated Effects of the Euro on Trade: Why are They Below Historical Evidence on Effects of Monetary Unions Among Smaller Countries?“The Estimated Effects of the Euro on Trade: Why are They Below Historical Evidence on Effects of Monetary Unions Among Smaller Countries?” in Europe and the Euro, edited by Alberto Alesina & Francesco Giavazzi (U. Chicago Press), 2010. “The Estimated Effects of the Euro on Trade: Why are They Below Historical Evidence on Effects of Monetary Unions Among Smaller Countries?” in Europe and the Euro, edited by Alberto Alesina & Francesco Giavazzi (U. Chicago Press), 2010. Europe and the EuroU. Chicago Press “The Estimated Effects of the Euro on Trade: Why are They Below Historical Evidence on Effects of Monetary Unions Among Smaller Countries?Europe and the EuroU. Chicago Press "Comments on 'The euro: It can’t happen, It’s a bad idea, It won’t last. U.S. economists on the EMU, 1989-2002,' by L.Jonung & E.Drea," slides. Euro at 10: Reflections on American Views, ASSA meetings, San Francisco, Jan.2009. slidesReflections on American Views slidesReflections on American Views "The UK Decision re EMU: Implications of Currency Blocs for Trade and Business Cycle Correlations,""The UK Decision re EMU: Implications of Currency Blocs for Trade and Business Cycle Correlations," in Submissions on EMU from Leading Academics (H.M. Treasury: London), 2003. Submissions on EMU from Leading Academics "The UK Decision re EMU: Implications of Currency Blocs for Trade and Business Cycle Correlations,"Submissions on EMU from Leading Academics "The Endogeneity of the Optimum Currency Area Criterion" (with Andrew Rose), "The Endogeneity of the Optimum Currency Area Criterion" (with Andrew Rose), The Economic Journal, 108, no.449, July 1998. The Economic Journal "The Endogeneity of the Optimum Currency Area Criterion" (with Andrew Rose), The Economic Journal “‘Excessive Deficits’: Sense and Nonsense in the Treaty of Maastricht; Comments on Buiter, Corsetti and Roubini,” Economic Policy, Vol.16, 1993.