1. Andrew K. Rose Berkeley, Haas
Much Ado about EMU
Andrew K. Rose
Berkeley, Haas
Andrew Rose , EMU

2. Beware Greeks Bearing Bonds
Sovereign default was inevitable
So far voluntary; “disorderly” to come?
Current Greek 10-yr bond >25%
German ≈1.5% (US, UK, Japan very low too)
Government Debt unsustainable (≈150% GDP)
German ≈ 80%
Big government deficits (≈10% GDP) imply continuing deterioration
German ≈ 1%
Andrew Rose, EMU

3. How Could This Happen? Article 103 (“No Bail-Out”) Maastricht Treaty
“… neither the Community nor any Member State is liable for or can assume the commitments of any other Member State”
But when push came to shove, spirit of Treaty violated
Andrew Rose, EMU

4. Evolving E-Bailout Institutions
European Financial Stabilization Mechanism (EFSM)
EC funds (from EU budget) of €60 bn
European Financial Stability Facility (EFSF)
May 2010: to “safeguard financial stability in Europe”
Can issue €440 bn of bonds, guaranteed by members, to lend to members “in difficulty” who request help, s.t. EC, ECB, IMF (“troika”) conditionality
Greece requested and received rescue package from EU/IMF (€110 bn), May 2010
Ireland and Portugal followed
European Stability Mechanism (ESM)
Permanent bailout kitty aka “Firewall”
Increased in late March 2012 to €500m, started 7/2012, fully ready by 2014 (!)
Probably still too small (German objections; France + others wanted €1 tn
EFSF + ESM limit is €700 bn
European Monetary Fund (EMF) started July 2012
Andrew Rose, EMU

5. How Did We Get Here?
Important to Understand Membership Requirements for EMU
Five “Convergence Criteria” required for entry
To be applied by the “Council of Ministers”
Mostly Economic, but Highly Politicized
Andrew Rose, EMU

6. Convergence Criteria, 1 Institutions Central bank independence Easy!
Andrew Rose, EMU

7. Convergence Criteria, 2 Inflation CPI inflation within 1.5% of target
Target is average inflation of three countries with lowest inflation
Still easy!
Andrew Rose, EMU

8. Convergence Criteria, 3 Interest Rates
Average long-term interest rates within 2% of target;
Target is average long-term interest rate of the three low-inflation countries
Note: some “wiggle-room” for sovereign risk premia
Again, easy!
Andrew Rose, EMU

9. Convergence Criteria, 4 Exchange Rates
Fixed Exchange Rates within “normal bounds” (15%!)
No realignment within last two years
Once more: easy!
Andrew Rose, EMU

10. Convergence Criteria, 5 Fiscal Positions
Members must have “Sustainable Government Financial Position” defined as:
Flow: Deficit/GDP ratio of less than 3%, and
Stock: Debt/GDP ratio of less than 60%
“Escape clauses” exist for “temporary circumstances” or declining debt
Not so easy!
Most scraped in
Greece lied its way in
Andrew Rose, EMU

11. Stability (and Growth) Pact
EMU “Ins” should maintain deficits of less than 3% GDP while in EMU or face penalties
German origins
Implies pro-cyclic fiscal policy (!)
Widely flouted by large countries in practice
France ‘03-’07, Germany ‘03-’06, Italy ‘03-?
Also breaches by Greece, Netherlands, Portugal
Reformed slightly in 2005
Revived at summit in December 2011
Andrew Rose, EMU

12. Hence More Fiscal Austerity
Considerable pressure on Greece to raise taxes, cut spending (and exacerbate 4-yr recession)
Portugal, Spain, Ireland too
German View: Roasting the Meat (or Burning it?)
But … will this work?
The markets don’t think so
Most commentators agree with markets
Right way to approach the problem?
Andrew Rose, EMU

13. How Should One Think about EMU?
Economists (and Haas MBA students) usually ask two questions on EMU
“Do European Countries look like an ‘Optimum Currency Area’?”
“Are European Countries similar to American Regions?”
Andrew Rose, EMU

14. “Optimum Currency Areas”
Mundell’s Nobel Idea: When are two regions more likely to gain from common currency?
If they share deep trade links and
Single currency reduces transaction costs of trade
If they have similar business cycles
Same monetary policy appropriate
Andrew Rose, EMU

15. But if Two Regions have Asymmetric Business Cycles …
Need to be able to Adjust to “Asymmetric Shocks” (good for one region, bad for another)
Otherwise boom in one region causes inflation
Recession in other causes unemployment
Costs of asymmetric business cycles can swamp (any) trade gains
Andrew Rose, EMU

16. One Way to Adjust (to Asymmetric Business Cycles)
Sharing risks
System of taxes/transfers
“Robin Hood” taxes rich, transfers to needy
Relieves unemployment, inflation
In principle, can do via private sector (international cross-holdings of assets)
Andrew Rose, EMU

17. An Alternative Adjustment Method
Factor Mobility
Unemployed workers move to places of high demand
Relieves unemployment and inflation
Andrew Rose, EMU

18. Mundell’s “Optimum Currency Area”
Suppose business cycles are asymmetric, and
There is a) little risk-sharing, and b) immobile labor, then
Gain from using differential monetary policy to smooth different shocks
Use different monies to adjust to different business cycles
Evidence within countries (e.g., American regions)
Evidence across countries (e.g., EMU)
Andrew Rose, EMU

19. Fiscal Austerity is not the Solution
It solves a different problem
Greek problem is poor competitiveness
Manifestations: current account deficit, slow growth, unemployment
Also true of other “Club Med” (Portugal …)
Classic example of “asymmetric shock”
Andrew Rose, EMU

20. Competitiveness within EMU
1999
2005
2006
2007
2008
2009
2010
2011
Real effective exchange rate (2005 = 100)
Germany
101.3
100.0
99.3
101.0
101.5
102.3
97.3
96.7
Greece
94.5
100.8
102.5
105.4
106.9
106.7
107.4
Italy
95.0
99.6
100.5
102.0
103.2
99.4
Portugal
92.7
101.8
102.7
102.1
99.9
Spain
90.9
106.1
106.3
103.7
104.3
Current account balance (% of GDP)
-1.3
5.1
6.3
7.5
6.2
6.0
5.7
-5.5
-7.6
-11.3
-14.6
-15.0
-11.2
-10.3
-9.8
0.7
-1.7
-2.6
-2.4
-2.9
-1.9
-3.5
-3.3
-8.7
-10.7
-10.1
-12.6
-10.9
-10.0
-6.5
-7.4
-9.0
-9.7
-4.8
-4.6
Andrew Rose, EMU

21. Bottom Line Greece has a fiscal problem
But solving it (if possible) won’t restore growth
Real problem: poor competitiveness limits growth, employment (Spain too!)
No easy solution for that
Hence … more serious crisis inevitable
Could easily be worse than Lehman
Andrew Rose, EMU