1. How can the Euro be stabilized? Günter Franke May 18, 2016 Kiev National Economic University

2. Overview What endangers the Euro? ECU-policy for highly indebted countries Greek Failure Policy of European Central Bank How to improve the European Currency Union?

3. What endangers the Euro? Euro: Common currency of 19 member states of the European Curreny Union (ECU) Stability of Euro determined by financial stability of main actors: member states, European Union, European Central bank price stability of Euro

4. What endangers the Euro? No member state should borrow heavily and then default, forcing other member states into support Historical examples of currency unions: currency unions broke apart whenever one member state tried heavily to make money at the cost of other states

5. What endangers the Euro? This motivated Maastricht criteria: For every member state Budget deficit ≤ 3% of GDP Public debt ≤ 60% of GDP In addition: to discourage free riding, bail out of a member state is prohibited

6. What endangers the Euro? 3% rule violated by France and Germany in 2003 other member states followed but no sanctions Financial Crisis 2008: many states violated Maastricht

7. Misallocation of money Investors believed in stability of € until 2009 → interest rates for government bonds of weak countries fell dramatically Spain: 14 % in 1992 4 % in 2006 Greece:25 % in 1992 4 % in 2006

8. Misallocation of money Effects: Spain: Construction boom, e.g. tourist homes at the Mediterranean coast, funded to a large extent by Spanish banks → large volume of non-performing loans leading to failure of Spanish banks

9. Misallocation of money Greece: Strong expansion of government expenditures Strong wage increases Essential: Additional loans not used for profitable investments, but for consumption → High debt burden, private and public

10. ECU-policy for highly indebted countries May 2010: government heads in Brussels chose policy: How handle crisis in ECU-member state?

11. ECU-policy for highly indebted countries Option 1: default of member state → would strongly hit bond holders: European banks European insurance companies other institutional investors and private persons

12. ECU-policy for highly indebted countries Default/insolvency of member state → default of several major European banks/insurance companies unless strong public support of these financial intermediaries → threat to Euro??

13. ECU-policy for highly indebted countries Option 2: Difficult to distinguish between insolvency and illiquidity of country. Allows to avoid default/insolvency of member state by claiming illiquidity only.

14. ECU-policy for highly indebted countries European Stability Mechanism ESM and Eur. Financial Stability Facility EFSF and IMF: Provide financial assistance (loans) to country in distress, subject to conditionality (economic reforms including cutbacks in budget deficit, economic reforms, privatizations, etc) Loans granted at low interest rates and with long maturity

15. ECU-policy for highly indebted countries Effect of option 2 on composition of bond holders Main bondholders: European Currency Union European Central Bank IMF

16. ECU-policy for highly indebted countries If anonymous crowd of lenders, these are never responsible for crisis of borrower. Only borrower responsible If only three major public lenders who impose conditions for lending, these lenders are made responsible for crisis, besides of borrower. → strengthens position of borrower continuous fights between borrower and lender

17. ECU-policy for highly indebted countries Austerity policy: -- major part of conditionality -- puts heavy burden on citizens Even if government supports austerity, big temptation -- to make main creditors responsible for burden -- to hide own political mistakes

18. ECU-policy for highly indebted countries ESM/EFSF support for Greece Ireland Portugal Spain Cyprus

19. ECU-policy for highly indebted countries ESM/EFSF support successful in Ireland with rather well-functioning economy Cyprus: Major burden on international depositors to local banks by bail-in

20. ECU-policy for highly indebted countries ESM/EFSF support partly successful in Spain due to weak economic structure and misallocation of capital Portugal due to weak economic structure and low level of education

21. Greek Failure Greece: Strong expansion of government expenditures Strong wage increases Essential: Additional loans not used for profitable investments, but for consumption → High debt burden, private and public

22. Greek Failure 2009 public debt/GDP 135 % budget deficit/GDP 15 % € 110 bio financial assistance to Greece, subject to conditionality New loans with artificially low interest rates

23. Greek Failure 2011 European governments forced banks and insurance companies to accept a debt relief on their bonds to Greece of about 100 bio € ESM, IMF and ECB took no losses

24. Greek situation today: wages came down by 30 % from 2010 until today Strong cuts in pensions yet public debt/GDP now 187 %

25. Greek Failure Austerity policy viewed by many Greeks as strong reason for misery → European Currency Union, in particular, Germany, held responsible Clearly, also other internal reasons (strong need for economic reforms including more leeway for competition, enforcing tax laws, reducing corruption)

26. Greek Failure Why no further debt relief for Greece? Would imply bail-out by ECU, ECB and IMF Other highly indebted countries might insist on debt relief → would undermine budget discipline even more and endanger Euro-stability

27. Greek Failure 3 requirements for Greek recovery Massive reduction of -- budget deficit -- bureaucracy ( and corruption) Massive debt relief (might only be feasible with Grexit)

28. ECB Role of ECB Monetary policy Banking for price stability supervision

29. ECB ECB policy of cheap money depresses yields on government bonds stimulates lending to firms and households stimulates stock and real estate price increases

30. ECB ECB policy of cheap money lowers budget deficits of many countries strongly Example: Italian deficit 2015 2.7 % of GDP Given public debt/GDP of 130 %, cheap money policy of ECB lowers budget deficit by ~ 3 % of GDP → otherwise massive violation of Maastricht criteria

31. ECB Puzzling role of ECB: without active ECB policy, €-crisis with active ECB policy: budget deficits much lower → necessary economic reforms in ECU- countries postponed Hence € fragile

32. How to improve the European Currency Union? How to stabilise Euro? Option 1: enforce much stronger political and economic integration together with fiscal discipline of ECU countries Presumably little support in most ECU countries evidenced by removement to nationalistic policies (refugee crisis)

33. How to improve the European Currency Union? Strong cultural differences among ECU countries: very difficult to agree on economic policies including competition policy, labour market legislation, government interventions in markets, fiscal policy

34. How to improve the European Currency Union? Currently no sign of convergence between different national cultures In the long run convergence ?

35. How to improve the European Currency Union? Option2: Strengthen economic independence and responsibility of ECU- countries Each country borrows in financial markets, not from ECU, ECB and IMF

36. How to improve the European Currency Union? Each country responsible for its financial health Unhealthy countries pay high interest rates → constrains borrowing Each country has more freedom in designing its economic policy

37. How to improve the European Currency Union? → clear cut responsibility of each country instead of confusion of responsibility between country and ECU cultural differences may persist

38. How to improve the European Currency Union? Would such a model work? Example USA. 50 member states + some territories use $ as single currency. Every state has its own strict rules for admissible budget deficits and borrows in financial markets.

39. How to improve the European Currency Union? How many states defaulted? Some states defaulted at end of 18th century, due to high expenses in independence war. US-congress helped these states.

40. How to improve the European Currency Union? Some states defaulted between 1830 and 1842, due to strong investments in infra-structure projects. US-congress denied help. Later on: no US states defaults except for Civil War and now Puerto Rico (US-territory).

41. How to improve the European Currency Union? No financial support of Washington for Puerto Rico. U.S. Congress would never help Puerto Rico repaying its debt. Automatic stabilisers: -- given bad economic performance of some state, then less transfer of state-tax revenues to federal government. Federal government may help state to fund expenses for health care and pensions.

42. How to improve the European Currency Union? Model might also work for Euro would reduce conflicts between ECU and its member states ECU would provide indirect help in case of problems and demonstrate solidarity. should weaken nationalist tendencies in ECU and promote the great idea of European unionisation