The debt crisis in the peripheral countries of the Euro area Alain Henriot Delegate Director, Coe-Rexecode, Paris AIECE Medium Term Group Essen, 6th May 2011

- 2 Different stories … but a same problem: public finances Greece: dynamic growth before the crisis, but heavy structural problems (tax collection) => structural measures directed towards a market economy Ireland: safe public finances before the crisis, but the burst of the housing bubble translated into heavy losses for banks: a huge cost for public finances => structural measures reshuffling the banking system, partly nationalized Portugal: low growth before the crisis, the consequence of changes in international sectoral specialization => structural measures accelerating changes in the economy Spain: when the housing bubble bursts … structural measures towards new engines of growth; rationalization of the banking system

- 3 Strong tensions on financial markets regarding the debt of peripheral countries

- 4 Consequences: questions about the future of the Euro area How can the Euro area survive with such different countries? What kind of economic policies for countries in difficulty? More solidarity or more discipline between member States?

The convergence process in the Euro area and its consequences on monetary policy 2. The policy mix in the Euro area since How coping with the debt crisis? Contents

- 6 Robert Mundell (1961), gave the basis for “a theory of optimum currency areas” :  A common currency can only be applied in areas or regions with the same economic structure or being able to converge quickly. A same monetary policy can be inappropriate in one country (or a group of countries) in case of differences in terms of economic structure. In this latter case, a possible remedy is a great mobility of production factors Question : What about the Euro area? What are the characteristics of an optimum currency area?

- 7 The level of GDP per capita differs among Euro area countries although there were signs of convergence during the last 15 years

- 8 GDP per capita (1995, Euro area =100) GDP per capita growth rate, % The poorest countries in 1995 registered the highest economic growth during the last 15 years

- 9 Because of the convergence process, we observed a higher economic growth in the peripheral countries before the crisis (except for Portugal) than the Euro area average … Real GDP growth (annual average, , %) Real Potential (Eur. Com. Estimates) Euro area (16 countries) 2,32,0 Germany 1,61,5 France 2,22,0 Greece 3,93,5 Spain 3,73,3 Ireland 7,26,8 Portugal 2,42,1

- 10 …, but real convergence also implied higher inflation in high growth countries

- 11 A similar business cycle, but with higher volatility in some countries

- 12 A limited mobility of the labor factor (large discrepancies in unemployment rates)

- 13 In the U.S. it also exists a discrepancy in GDP per capita even if it seems lower than in the Euro area Dispersion of GDP per capita in the U.S. and in the Euro area U.S. (2008)Euro area (2009) Standard deviation of nominal GDP per capita19,129,2 (American States and EA-15)* Standard deviation of nominal GDP per capita10,522,2 (8 U.S. regions and EA-11)** * Excluding Columbia district for the U.S. and Luxembourg for the Euro area which are extreme points ** Euro area exluding Luxembourg, Cyprus, Malta, Slovakia and Slovenia

- 14. More mobility of the labor factor in the U.S? Not so sure recently as large discrepancies in the unemployment rate remain Unemployment rate (Feb. 2011): lowest North Dakota 3,7%, U.S. average 8,9%, highest Nevada 13,6%.. Differences in terms of inflation trend seem rather small: March 2011/ March 2011: Northeast urban 2.5%, Midwest urban 2.7%, South urban 2.8%, West urban 2.6%, USA: 2.7% A comparison U.S./Euro area

- 15. Differences in economic structure, although convergence has improved. Strong integration is visible in the high correlation between national business cycles.. Real convergence implies higher real GDP growth, with consequences in terms of higher inflation (this is the major difference with the U.S.). => Real convergence creates a dilemma for monetary policy in a single currency area, especially because not so much mobility in the labor market. To sum up: The Euro area has not all the characteristics of an optimum currency area, although signs of improvement have been noticed before the crisis

- 16 Productivity => 2 – if the Euro area is not an optimal currency area, what kind of problems can emerge? GDP per capita Wages => Inflation: tensions in the economy (low unemployment rate or decreasing unemployment rate), “Balassa effect” (increase in non internationally tradable goods prices, e.g. services as real convergence implies also nominal convergence of price levels) =>  Appreciation of the exchange rate and increase in interest rates BUT this was not possible in the Euro area for converging countries In an economy which is moving towards the technological frontier we can observe the following developments:

- 17 An application of the Taylor rule An application of the Taylor rule : ECB Repo = average annual growth of potential output ( ) – 1 (difference between long term and short term interest rates) + inflation * output gap (real GDP/potential GDP) (inflation rate -2 the ECB target) Has monetary policy been appropriate to the economic situation since 2000?

- 18 Between 2000 and 2008, monetary policy was restrictive for Germany and expansionist for countries which were converging

- 19 Consequences: monetary policy has exacerbated internal disequilibrium

- 20 External disequilibrium reflected internal disequilibrium (except in Ireland)

- 21 No compensation (or not enough) through fiscal policy

- 22. Monetary policy was appropriate for the Euro area as a whole but not for all individual members. This was not a mistake of the ECB but the consequence of the real convergence process (a political target, supported by various instruments, e.g. structural funds). To equilibrate the policy mix, fiscal policy should have been more restrictive in peripheral countries and more relaxed in Germany (the opposite was done). But was it politically possible (Spain close to the equilibrium, Ireland registered a fiscal surplus)? To sum up: monetary policy was appropriate for the Euro area, but internal divergences were (almost) inevitable

- 23 Is there any exit strategy from the Euro area? NO. There is not a symmetry between entering and leaving the EMU: technically, what would be the value of the private or the public debt for the country leaving the EMU? If there is a strong depreciation of the new currency (50% or more), the increase of the external debt will not be sustainable.. Which value for the new currency? In the short run, a depreciation of the currency increases the competitiveness, but if it is followed by a strong rise in the inflation rate, interest rates would be pushed up: as a consequence GDP might be hit negatively and competitiveness would deteriorate.. Consequences on remaining countries are not clear. It might lead to an increase in interest rates in EMU Member States and to a lower intra-Euro area demand. 3 – What’s next?

An exercise regarding the sustainability of the public debt in the Euro area countries : Coe-Rexecode outlook (Spain) and European Commission (Portugal, Italy, Greece) Dec : Assumptions : - Real GDP close to potential growth (revised downward compared to the pre-crisis period; - Euro area inflation close to 2% (a bit higher inflation for peripheral countries) - Apparent interest rates in line with growth of nominal GDP, including a risk premium. - Public receipts increase as nominal GDP - Public expenditures are adjusted to stabilize the debt/GDP ratio in the medium run (when possible) Reminder: If Bp(t)=G(t)-T(t), the primary deficit, with G(t) the public expenditures (excluding payments) and T the public receipts Total fiscal deficit is B(t) = Bp(t) + r(t)D(t-1), where interest payments is the product between the apparent interest rate and the debt level It comes, D(t) = D(t-1) + B(t)= Bp(t)+(1+r(t))D(t-1) And in % of GDP, the debt dynamics can be written: d(t) = bp(t) + (1+r)/(1+g) d(t-1), with r the apparent interest rate and g the nominal GDP growth rate.

Underlying assumptions of a scenario on the public debt sustainability SpainPortugalGreeceIreland Real GDP growth rate GDP deflator growth rate 2.5 Fiscal receipts growth rate 5,04.55,0 Fiscal expenditures growth rate Apparent interest rate (average level) Main assumptions (%, annual average )

The stabilization of the debt/GDP ratio is possible, but only in the long run (around 2015) Outlook of public finances in peripheral Euro area countries (% GDP) Spain Primary balance Fiscal balance Public debt Portugal Primary balance Fiscal balance Public debt Greece Primary balance Fiscal balance Public debt Ireland Primary balance Fiscal balance Public debt

What can be learnt from this numerical exercise? Debt dynamics (the snowball effect) is clearly heavily dependant on the level of interest rates: what is sustainable with a 5% interest rate is not anymore sustainable with interest rates at 10% (nominal GDP growth has to increase by the same proportion!). In the long run, peripheral countries can stabilize the debt/GDP ratio with a better discipline regarding fiscal policy. A shock therapy is not needed (it can have a counterproductive effect, see Greece in 2010). It is necessary to “buy time”. This is exactly the target of the future European Stability Mechanism. It can be a triple win process: no cost for other EMU members states (loans, no gift); no losses for banks (different from the default case); a sustainable process for peripheral countries.