The Euro Crisis: A short guide Jean-Bernard Chatelain (CES, Paris 1 Panthéon Sorbonne) Kirsten Ralf (ESCE)

Plan 1.The global crisis: fall of asset prices, fall of confidence in international banks 2.The Euro crisis: asymmetric response to the fall of asset prices or of output for south (PIIGS) and no fiscal transfer from the north 3.Ongoing policies and dilemma 4.Conclusion

1.1 The start of the global crisis The misvaluation of assets led to unreliable balance sheets of international banks, which triggers the persistent lack of confidence between banks and the persistent threats of liquidity crisis and bank runs.

1.2. The spread of the crisis The fall of asset prices led to a credit crunch and a fall of output. The lack of trust on the interbank market led to a persistent increase of M0, central bank money creation and near zero interest rate. Governments bailed out banks and there is a persistent probability of bailing out again. Hence government debt increased.

Persistent Quantitative Easing, towards QE3 (january 2012)

1.3. Government crisis In 2008, keynesian fiscal policy was done along with the fall of output (decreased tax income) and the bailout of banks: large increase of public debt. In the US: no governement default. But in the Euro area: the North does not do fiscal transfers to the South: hence probability of default by the South (Portugal, Ireland, Italy, Greece, Spain).

2. Asymmetric crisis shock in the Euro area A common qualitative shock: no longer trust between banks everywhere. However, asymmetry of the effects on output of asset prices, public expenditures « resilience », exports, or other consumption and investment channels of demand.

PIG + IS Ireland and Spain: large sensitivity on output loss to the fall of asset price (far from average value), large effets on banks solvency. (time to come back to normal price: 7 years) Portugal, Italy, Greece: milder effect above, but weak tax system and large initial debt (time to change tax compliance: years).

Asymmetric loss of output The sensitivity of output loss of PIG+IS to the global crisis (fall of asset prices, lack of confidence in banks) have been larger than in the North through various channels in : - Housing price freefall and banks exposure -Exports (competitivness) and tourism -Public spending contraction + expectations driven sovereign crisis.

Building asymmetric response to the crisis shock Catch up GDP/head with common interest rate policy of North (restrictive) by South (expansionary). In the South: Higher growth (convergence of GDP/head), higher inflation (Balassa), higher rise of asset prices, higher rise of nominal wage (loss of price competitivness/Germany: low inflation). Divergence of GDP per head (Sudden stop like emerging economies)

In crisis, budget deficits correlation increased with current account deficits: R2=0.16 to 0.60

Current accounts, house price bubbles.

Budget deficits% GDP, 2010

Bank runs + Government sovereign debt Banks restrict credit, fall of demand: loss of output and loss of tax income: « Real channel of public deficit. » Banks liquidity problem: « Pending or real lender of last resort channel of public deficit (bad expectations driven equilibrium)». Banks buy sovereign « not-safe » asset with undervalued risk: joined default.

The North does not insure (nor do fiscal transfers to) the South Then, investors and laymen weight a non zero probability of partial default of South sovereign debt (and/or exit of Euro) And of systemic default of all European banks (North and South). Deposit runs and sudden stop from South to North.

3.1. Policy debate and timing: sovereign Sovereign debt: Surplus (no deficits)= Austerity (fatigue) Redeem debt Low interest rate (but risk premium) High growth (expansionary austerity?) Cash to banks coming back (but positive feedback to low bank run equilibrium).

3.2. Banks systemic risk, banking union Targeting common insurance (« systemic risk sharing with transfers») Lender of last resort (ECB cash M0) EU deposit insurance fund Common Basel3 rule Common regulator, supervisory rules. Future macro-prudential policy, capital controls?

3.3. Fiscal rules, fiscal transfers and fiscal policy Increase the EU control of budgetary policy in nation state (moral hazard). Conditional Eurobond for a proportion of debt. Expansionary Fiscal policy in the North (equivalent to a fiscal transfer)? Write down again (Greek) debt (ordering who’s going to pay for the losses).

3.4. Long term competitivness Wage competitivness / China exchange rate? Non price competitivness: innovation and industrial policy, and limit destructive destruction of the depression (loss of learning by doing, large unemployment).

Remark: not an optimal currency area Free financial and real capital Some migration labour mobility, flexible price and wages. Endogenous convergence in some directions versus building reaction asymmetries to the global crisis. Key issue is Fiscal Transfers.

4.1. Optimism?! The irreversibility bet paradox: the cost of exit of the Euro is so large. Extreme shock in Greece But EU built up over time a number of coordination institutions = compare to in Europe. Euro- meetings versus exchange rate crisis. Fiscal transfer are NEVER easy and always guaranteed (north south inside European countries, non progressive taxation).

4.2. Tensions Germany and North versus South Timings: reforms with many different horizons (changing tax compliance: count 20 years). Center politicians-technocrats versus Extremes (Crisis foster extremes BUT technocracy knows about it). Financial-liberalism versus Social Europe. Austerity versus North fiscal policy

4.3. Turning point Exit, break up. Versus the Euro irreversibility bet: Going on to further integration, banking union and fiscal coordination, a global reward to the Greek and PIIGS people’s pain. Democratic opposition versus international federalism (instead of nation state) versus International economic integration (Rodrik)

Thanks for your attention!