1. Sixten Korkman 18.3.2013, Stockholm The Euro Area Debt Crisis  Where are we now?  Where did the euro train start?  What went wrong?  Why is it so difficult to get out of the mess?  Is the current, acute crisis manageable, how?  What vision for the future of the EMU?  Was it a mistake of Finland to join?  Bottom line?

2. 1. Where are we now? In a mess:  The banking system is fragile/faces strains - though the fear of a financial collapse with an escalating banking crisis and a buyers’ strike in sovereign debt markets (Italy, Spain) has decreased in recent months  Most countries are in a recession (some in a depression) - and in the crisis countries there is no alternative to austerity  the divergence between developments in the North and in the South is widening, and social problems in the latter are increasingly serious  political conflicts within Europe: North-South, rise of anti-European populism (in all countries), disagreement on the mandate of the ECB, a widening of the British channel…  In all, the situation in Europe is more dangerous than ever since the start of the EU

3. Divergence: GDP of countries with a high rating versus the GIIPS Anssi Rantala 13.2.2013

4. 2. Where did the euro train start?  political background: WWII, German reunification, the political imperative  economic background: exchange rate turbulence and the need to protect the internal market; the “impossible trinity”  personalities matter(?): Kohl, Mitterand, Delors…  NB: French and German views on economic policy differ starkly  NB: the Maastricht Treaty set up a currency without a state  NB: the institutional basis of the EMU as set up is quite thin, consisting mainly of the ECB, the no bailout rule and the SGP (rules for budget discipline)

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

7. What went wrong?  generic problems: 1) deficit bias in public finances 2) inherent instability associated with modern finance (occasionally excessive leverage causing boom and bust) 3) lack of balance between global economy and local/national politics  flaws in the set-up of EMU: 1) the no bailout rule was not made operational and all sovereign bonds were treated as risk free (by the BIS and ECB) 2) no lender of last resort for sovereigns, risk of “multiple equilibria” 3) reform of labor markets was insufficient or lacking 4) strong links between national sovereigns and banks proved dangerous  specific mistakes (avoidable): 1) membership in the euro area became too encompassing 2) the SGP was not respected (the fiscal rules) 3) no action was taken to strengthen the banking system 4) countries in the South misused the fall in interest rates (and debt service) by increasing public and private spending

8. 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

10. Why is it so difficult to get out of the mess?  reducing debt leverage takes time (Reinhart & Rogoff)  lack of willingness to face the banking problem (cf. the US)  numerous negative feedback loops (including between banks and sovereigns, self- fulfilling expectations?)  action has focussed on preventing future crises, not this one (reform of the SGP with 6- pack and 2-pack and fiscal compact, economic surveillance etc)  the ”legacy cost” is difficult to deal with (e.g. Spanish banks)  there is a chicken game going on between North and South?  lack of leadership inherent in the construction (which MD tries to deal with)  politicians caught in a difficult cross fire (markets, citizens)

11. 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)

13. 6. What vision for the future of EMU?  Banking union: regulation, supervision, crisis resolution, deposit insurance (cf. California)  Fiscal union: eurobonds + supranationally imposed budget discipline  Political union: the United States of Europe There are various views on the appropriate vision. However, the presently agreed line is that setting up the banking union is the way to go. This will require a ”minimum fiscal backstop” (perhaps the ESM, the permanent crisis fund), but this can be small if regulation and supervision is tight and bail-in is implemented forcefully. OK, if it can be agreed and implemented credibly. How about the outs? There is a case for joining, because banking spillovers are not constrained to the euro area, and there is otherwise a risk of negative consequences for banking in outs. But then outs will also have to be part of the minimum fiscal backstop? (Too early to evaluate the constellation.)

15. Yields on Italian 10 government bonds

16. Yields on Spanish 10 government bonds

17. The long shadow of the crisis: unemployment Anssi Rantala 13.2.2013

18. FINLAND  Why did Finland join the euro area, was it a bad mistake?  Should Finland Fixit? (Short answer: No)

20. Bottom line  The basic political and economic case for EMU is open to question: may be setting up the monetary union was not a great idea; at least the design was flawed (but there is no counterfactual)  Presumably the flaws in the design have been identified and they can be corrected, notably by setting up the banking union (if agreed upon and implemented correctly)  The euro is practically irreversible (even if some small member state might exit): a collapse of EMU would trigger a political/economic catastrophe (TINA applies?)  The crisis pushes crisis countries to a path of long-overdue reforms?  The political commitment to the EMU remains strong  Muddling through seems realistic  Finnish proverb: what does not kill you, will strenghten you