The European Economic Crisis: Origins and Prospect for the Future Andreas Hauskrecht Kelley School of Business Institute for European Studies Indiana University

What Is the EMS? The European Monetary System was originally a system of fixed exchange rates implemented in 1979 through an exchange rate mechanism (ERM). The EMS has since developed into an economic and monetary union (EMU), a more extensive system of coordinated economic and monetary policies. The EMS has replaced the exchange rate mechanism for most members with a common currency under the economic and monetary union.

Membership of the Economic and Monetary Union To be part of the economic and monetary union, EMS members must first adhere to the ERM: exchange rates were fixed in specified bands around a target exchange rate, next follow restrained fiscal and monetary policies as determined by Council of the European Union and the European Central Bank, finally replace the national currency with the euro, whose circulation is determined by the European System of Central Banks.

Theory of Optimum Currency Areas The theory of optimum currency areas argues that the optimal area for a system of fixed exchange rates, or a common currency, is one that is highly economically integrated. economic integration means free flows of goods and services (trade) financial capital and physical capital workers/labor (immigration and emigration)

Incentives to be a member of the Euro area Financing cost for government debt of European countries were significantly higher than for Germany. By joining the Euro these countries lowered their government (and corporate) by several percentage points, which has significant positive impact on economic activity (GDP growth).

Decreased Bond Spread with Germany Decreased Default Risk and Inflationary Risk Governments able to refinance debt and borrow new capital cheaply Italy specifically gained from this with their historically high debt Italy Official Introduction of Euro Spain Greece Ireland GER=0 Source: OECD

The costs of being a Euro member Before joining the euro area, many countries had a history of higher inflation, rising wage cost, and fiscal deficits, which undermined their international competitiveness. Regularly they used exchange rate corrections (a depreciation of domestic currency) to restore their international market position. By joining the Euro, this instrument was given away.

Bonanza After joining the Euro area the countries enjoyed a Bonanza. Low cost to finance the government debt, and significant inflows of capital, which caused in some countries such as Ireland and Spain, significant increases in real estate prices and healthy GDP growth rates.

Convergence or Divergence Advocates of a monetary union expected main macroeconomic variables in member countries to converge. In particular: Inflation Productivity Labor cost Economic performance. And exactly the opposite happened.

Unit Labor Spreads with Germany (2000 =0) Unit Labor Cost Unit Labor Output = ∆ Wages - ∆ Productivity Greece Spain Ireland Italy GER=0 Official Introduction of Euro Unit Labor Spreads with Germany (2000 =0) Wrse Source: OECD

Market reaction: Spreads with German 10 year Treasury Bond

The Markets price in the possibility of a government debt default As a market reaction, government bond spreads increased, which made it more and more difficult for these countries to refinance their government debt. Greece, Ireland, and Portugal needed a bail out from the Euro member countries and the IMF to avoid straight default. But a financing of debt in itself, does not help restore competitiveness.

Digging the hole deeper and deeper The Nordic Euro member countries see the problems of southern countries homemade. Fiscal deficits, high debt burdens, unreasonably high wages and benefits. So they asked for austerity policies for precondition for bailouts. The so-called bail out programs by the IMF and the European Union focused on helping financing the debt payments, but not, or insufficiently cut the overall debt burden.

New Safety Architecture In September the European Stability Mechanism (ESM) was founded with a budget of Euro 500 billion, replacing earlier funding facilities (EFSF, EFSM). The ECB will be in charge of supervising the larger banks. A Banking Union is envisaged with the aim to harmonize regulatory and supervisory standards.

Vicious Circle And the vicious circle began: cut in government spending, recession, lower government revenues, higher debt burdens, new round of bailouts (Greece). The economies are shrinking, unemployment increases, so does the government debt burden.

Sustainable Public Debt Sustainable defined are a constant or decreasing debt/GDP ratio. The change in the debt/GDP ratio = (real interest rate – real GDP growth rate)*(debt/GDP from previous year) + (primary deficit/GDP from current year) Even with a balanced budget (deficit=0) or a small surplus, debt can be unsustainable is the real interest rate is too high or the real GDP growth rate is too low!

How does this work for Greece? Real interest rate to finance the government debt: nominal interest minus inflation (plus deflation) 10 + 1 = 11 percent Government debt end of 2012 157 percent Real growth rate: -3.2 percent (very optimistic) Primary budget: 0 percent 157 * .11 = 17.3 - -3.2 percent + 0. In other words the Greek government debt will increase in 2013 by more than 20 percent, at least

Why not just bail them out once for all Why are the Nordic countries so hesitant to run a big once for all bailout? The domestic tax payers show resistance; Moral hazard. Bail the out, and they do it again. So what can we expect for the future? Greece will very soon need a new rescue package Very likely, this will also be the case for Portugal. Also Spain and Ireland will have to ask for further assist

The Future However, refinancing debt payments will not enable these countries to grow out of the crisis. How long of a recession and high unemployment can these countries sustain, before political instability occurs or gets worse. The crisis is not over yet.

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