Lecture III, June 1, 2012 The Euro Crisis

Institutions of Macroeconomic Policy

Jeffrey FrankelHarpel Professor

Advanced Workshop on Global Political Economy,Institute for Global Law & Policy, Harvard Law School

Lecture III, June 1, 2012The Euro Crisis

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Was European Monetary Union a bad idea from the start?

Seven implementation mistakes by euro leaders

Looking forward:– What now?

Was European Monetary Uniona bad idea from the start?

Pros:Monetary: A firm nominal anchor to end inflation among Mediterranean countries.Trade: To promote EU economic integrationPolitical: To improve cohesion.

Cons:Monetary: Loss of ability by each to respond to local conditions by adjusting money supply, interest rate, or exchange rate.

Political (according to Feldstein): Could lead to conflict.

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The major grounds for ex ante skepticism among (American) economists

The euro countries did not meet the criteria of an Optimum Currency Area

– Bob Mundell, 1961 (another Nobel Prize).

Individual member countries would be hit by individual shocks.– Lacking the high labor mobility of the US,

– where workers adjust to unemployment by moving across states,

– euro members would find it very difficult to abide by a common monetary policy.

– E.g., when a periphery country suffered a loss in demand, the interest rates set in Frankfurt would be too high for it.

4Comments on “The euro: It can’t happen, It’s a bad idea, It won’t last. U.S. economists on the EMU, 1989-2002,” by Jonung & Drea. Euro at 10, 2009 ASSA mtgs.

In retrospect, economists were correct to worry about “asymmetric shocks”

But (1) the shocks were excessive credit-fueled booms in the periphery countries (2003-07), rather than recessions,– with Ireland & Spain unable to raise interest rates or appreciate; and

(2) the booms showed up in asset prices (housing)– rather than in goods market inflation.

(3) Only after the Global Financial Crisis began in 2008– was the need felt to fight recession with depreciation

E.g. Poland had the best performance, the Baltics had the worst.

And only after the Greek crisis began in Oct. 2009did the need to devalue become so acute as to prompt thoughts of leaving the euro.

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But the Maastricht Treaty (Dec. 1991)focused on fiscal criteria

as qualifications for euro membership:

BD < 3% of GDP & Debt < 60% of GDP.

One might have thought that, giving up the instrument of monetary policy, it would become more important for countries to retain the instrument of fiscal policy.

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Why did the designers of Maastrichtemphasize fiscal criteria?

Theory I: Jason & the Golden Fleece

Theory II: Theseus & the stone

Theory III: Odysseus & the sirens.

Frankel, Economic Policy (London) 16, April 1993, 92-97.

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The motivation for the Maastricht fiscal criteria

was the same as for the No Bailout Clauseand the Stability & Growth Pact (1997):

Skeptical German taxpayers believed that, before the € was done, they would be asked to bail out profligate Mediterranean countries.

European elites adopted the fiscal rules to render these fears were groundless.

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7 mistakes made by euro leadersAdmitting Greece to the € in the first place, – a country that was not yet ready by the relevant criteria.

Pretending to enforce the fiscal criteria.

Allowing Mediterranean countries’ bond spreads near 0– helped by investors’ under-perception of risk (2003-07)– and artificial high credit ratings. But also– ECB acceptance of Greek bonds as collateral.

Burying their heads in the sand when the crisis hit in late 2009:In early 2010, sending Greece to the IMF was “unthinkable.”In early 2011, restructuring of the debt was “unthinkable.”

The current strategy: austerity for now, unenforceable “Fiscal Compact” for the future.

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After the euro came into existence

it became clear the German taxpayers had been right– and the European elites had beene wrong.

E.g., Greece persistently violated the 3% deficit rule.

All countries violated the rules, large and small

SGP targets were “met” by overly optimistic forecasts.

SGP threats of penalty had zero credibility.

Yet each year the ostrich elites stuck their heads deeper & deeper into the sands.

The Greek budget deficitnever got below the 3% of GDP limit,

nor did the debt ever decline toward the 60% limit

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Even Greece’s primary budget deficithas been far in excess of 3% since 2008

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Source: IMF, 2011.I. Diwan, PED401, Oct. 2011

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Spreads for Italy, Greece, & other Mediterranean members of € were near zero, from 2001 until 2008.

Market Nighshift Nov. 16, 2011

When PASOK leader George Papandreou became PM in Oct. 2009,

he announced – that “foul play” had misstated the fiscal

statistics under the previous government:

– the 2009 budget deficit ≠ 3.7%, as previously claimed, but > 12.7 % !

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Missed opportunity

The EMU elites had to know that someday a member country would face a debt crisis.

In early 2010 they should have viewed Greece as a good opportunity to set a precedent for moral hazard:– The fault egregiously lay with Greece itself,

unlike Ireland or Spain, which had done much right.– It is small enough that the damage from debt restructuring

could have been contained at that time.

They should have applied the familiar IMF formula: serious bailout, but only conditional on serious policy reforms & serious Private Sector Involvement.

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But the ostriches stuck their heads ever further down in the sand.

Eventually – Greece, Ireland and Portugal went to the IMF; and – Greek debt was restructured.

But by then interest rates and debt/GDP ratios were far higher, it was too late to draw a line credibly distinguishing Greece from the others, even Spain and Italy.

Any solution to the euro crisis must include:

(i) a way of putting the member countries back on sustainable paths (≡ debt/GDP declining).

(ii) a way of preventing repeats in the future.– As the Maastricht architects knew all along,

this means a way of preventing fiscal moral hazard: preventing individual countries from running big deficits & debts, expecting to be bailed out in the event of a crisis.

(i) Putting countries back on sustainable paths?

The 6th mistake: the German belief that fiscal contraction is expansionary.– It is the same mistake made now by the UK & some in the US,– and is the same mistake made in 1937.

As a result, Debt/GDP ratios in euro countries are rising, – not falling;

= the definition of unsustainable financially,

even if you thought the economic hardship was sustainable politically.

(ii) Preventing moral hazard in the future?

The 7th mistake is Merkel’s “fiscal compact”:– yet another unenforceable declaration

of determination to strengthen the SGP,– via budget limits in national laws/constitutions.

– Why should these rules be any more credible than those that came before?

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EMU Ostrich

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References by the speaker

“The ECB’s Three Big Mistakes,” VoxEU, May 16, 2011. “Optimal Currency Areas & Governance", slides session on the Challenge of Europe at the Annual Conference of George Soros’ INET, April 2011; video available, including my presentation. "Let Greece Go to the IMF," Jeff Frankel’s blog, Feb.11, 2010.Over-optimism in Forecasts by Official Budget Agencies and Its Implications," 2011, forthcoming in Oxford Review of Economic Policy.“A Solution to Fiscal Procyclicality:  The Structural Budget Institutions Pioneered by Chile,” Fiscal Policy and Macroeconomic Performance,  Central Bank of Chile, 2011.  NBER WP 16945, April 2011. “The Estimated Effects of the Euro on Trade:  Why are They Below Historical Evidence on Effects of Monetary Unions Among Smaller Countries?” in Europe and the Euro, Alberto Alesina & Francesco Giavazzi, eds. (U.Chic.Press), 2010.    "Comments on 'The euro: It can’t happen, It’s a bad idea, It won’t last. U.S. economists on the EMU, 1989-2002,' by L.Jonung & E.Drea," slides. Euro at 10: Reflections on American Views, ASSA meetings, San Francisco, 2009. "The UK Decision re EMU: Implications of Currency Blocs for Trade and Business Cycle Correlations," in Submissions on EMU from Leading Academics (H.M. Treasury: London), 2003."The Endogeneity of the Optimum Currency Area Criterion," with Andrew Rose,    The Economic Journal, 108, no.449, July 1998.“‘Excessive Deficits’: Sense and Nonsense in the Treaty of Maastricht; Comments on Buiter, Corsetti and Roubini,” Economic Policy, Vol.16, 1993.  

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Appendices:

• (A) In the US system, how do the fiscal policies of the 50 states avoid moral hazard?

• (B) The ECB’s LTROs (Dec. 2011-Feb 2012)

• (C) Any solution for the long term?

Appendix A: Perhaps the Fiscal Compact misunderstands the US system

Yes, despite a common currency, the 50 states do not seem to have moral hazard:– the federal government has never bailed one out,

and nobody expects it to now.– But that is not because of the budget rules

that (49 of) the states have.Their rules are voluntary, varied, and flexible.Some states do have debt troubles,

– and even default.

How the US avoids moral hazard in the 50 states

Government spending at the state level is a far smaller share of income than at the federal level, – let alone on the part of European states.– Is Europe ready for that? No.

When one state begins to run its debt too high, the private market automatically imposes an interest rate penalty.– E.g., California today.– Gives states the incentives to get back in line.– This mechanism was expected to operate in euroland

Alesina, et al (EP, 1992) and Goldstein & Woglom (1992).

but conspicuously failed from the first day.– Which showed that moral hazard had not been addressed.

Nobody expects the U.S. Federal government to bail out indebted states: The precedent was set

170 years ago, when 8 states were allowed to default.

25When States Default: 2011, Meet 1841, WSJ

In the early 1940s,5 states repudiated their debts completely(Michigan, Mississippi, Arkansas, Louisiana & Florida) while a few more were in default for several years.

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Spreads help keep profligate US states in line= reason why no state has ever been bailed out by

the Federal government, despite some defaults.

26Source: W.B. English, „Understanding the costs of sovereign default …,“ p. 269. as used by Holtfrerich (2011)

Yield tomaturity

in %

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California Municipal Bonds(now the lowest rated of the 50- states)

Credit Default Swapshttp://blogs.reuters.com/muniland/2011/06/08/muni-sweeps-lockyer-rides-again/

Appendix B: Mario Draghi became President of the ECB, Nov.1, 2011

He was under intense pressure to expand his predecessor’s purchases of large quantities of periphery-country bonds.– The ECB was urged to be the “big bazooka”:

to buy troubled governments bonds.– If the ECB interpreted its mandate literally,

as no more than keeping inflation low, then the euro might break up.

On the other hand, as Draghi knew:– the ECB is legally prohibited from financing governments directly;– If he had bailed out Italy & the others, he would have:

facilitated a continuation of Berlusconi-style irresponsibility;been immediately written off by Germans as another profligate Italian.

Draghi’s LTRO (Longer-Term Refinancing Operation) was a great success.

On Dec. 22, he caught everyone by surprise by the clever ploy of doing exactly what he had previously announced he would do:– loans to banks for 3 years, at low interest.

High take-up– Brought down interbank & country spreads,

while consistent with central bank LoLR mandate.

2nd round in late February was equally successful. But the LTRO rounds were not a solutions;– They only bought a little time.

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Appendix C: Proposal for the long term #1

Emulate Chile’ssuccessful fiscal institutions:

Give responsibility for determining what is a structural deficit and what is a cyclical deficit to an independent professional agency, to avoid forecast bias.

(Frankel, 2012)

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Proposal for the long term #2

Penalty when a euro country misses its target:a) The ECB then stops accepting new bonds as collateral.b) => Sovereign spread rises, with automaticity.

c) Proposal from Brueghel (JvW & ZD): All of euroland is liable for blue bonds

(issued up to SGP limits); Issuing country is liable for red bonds

(beyond those limits) .

d) Blue bonds share advantages with other eurobond proposals:

a) ● ECB can conduct monetary policy.b) ● They could offer an alternative to US TBills

for PBoC & other desperate global investors

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Blue bonds & red bonds

Gavyn Davies, FTSource:

Jeffrey Frankel

Advanced Workshop on Global Political Economy,

End of Lecture IIIThe Euro Crisis