Saving the

Saving the SIMEON DJANKOV

JUNE 14, 2013

What is the Euro? “The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does. And now – and I think people ask “how come?” – probably there was something in the atmosphere, in the air, that made the bumblebee fly. Now something must have changed in the air, and we know what after the financial crisis. The bumblebee would have to graduate to a real bee.”

Who said this?

Who Said This?A. Silvio BerlusconiB. Paul KrugmanC. Mario DraghiD. Jean-Claude Juncker

This is how Ecofin felt for a long time…

“At every juncture [policymakers] made the minimum commitments necessary to avoid imminent disaster – offering optimistic rhetoric, but never taking the steps that even they believed could offer the prospect of decisive victory. They were tragically caught in a kind of no-man’s-land – unable to reverse a course to which they had committed so much, but also unable to generate the political will to take forward steps that gave any realistic prospect of success.”

Daniel Ellsberg on the Pentagon Papers

What is the Problem?o Third consecutive year of recession in the Eurozoneo Average debt burden of around 90% of GDP and risingo Unemployment at record-high, 12.2% in April 2013oUnemployment in Greece and Spain at 27%oYouth unemployment in Spain at 62%o Ireland, Greece, Portugal, Spain and Cyprus with bailout packageso Slovenia, Italy next?

What is the Real Problem?o In 2012 France ran a current-account deficit of €82 billion, Spain €32 billion, Greece €20 billion, Portugal €11 billion and Cyprus €4.3 billion. Germany ran a surplus of €170 billion.o In 2013 it takes 11 procedures and €9,000 to open a small business in Athens. It takes 735 days and 43 procedures to resolve a simple commercial dispute in Larnaca, Cyprus. And it takes 59 days and visits to eight different offices to register a small piece of property in Paris. It is cheaper and faster to do all this in Berlin. o In 2012 the share of the population of the ages 25–64 that has completed high school is: Portugal 38 percent, Spain 54 percent, Italy 57 percent, and Greece 66 percent. In Germany it is 88 percent.

Solution #1: Euro Holidayso Greece goes off the euro and lets the drachma depreciate to 1 euro equaling 1.30 drachma. o The country commits to rejoin at a depreciated exchange rate in the future (say in 3 years) while in the meantime does the reforms necessary to keep it competitive in the long run. o Bank balances remain in euro, so as not to cause a run on the banks.o Example: Argentina in 2001, ending the dollar peg. In one year, the peso fell to a quarter of its previous value, imports declined in half, and inflation rose to 44%.

Issues with Solution #1o All contracts would have to be re-written in the new currency. Vending machines and meters would have to be rewired.o At best, the euro holiday would take a year to happen.o It would damage the balance sheets of banks (say French banks) that hold Greek assets. o The defector would be shunned in European discussions of nonmonetary issues.

Solution #2: The Northern Euroo Austria, Finland and the Netherlands exit the euro first and build up the Northern Euro.o Germany joins, followed by the Baltics, the Czech Republic, Slovakia and Bulgaria. o The Southern Rim countries remain in the existing euro. After initial inflation they benefit from a strong devaluation.o That would make their manufacturing exports and tourism competitive. It would also allow for their own (more expansionary) monetary policy.

Issues with Solution #2o German industry and exporters will complain about the strong Northern Euro.o The central banks of the Northern Euro and the Southern Euro will need to work together to prevent a sudden appreciation of the Northern Euro. o It is unlikely that the Greeks, Spaniards, Portuguese and Italians will be able to agree on the policy coordination.o Europe might be left with a strong Northern euro and a group of weak southern currencies.

Solution #3: Eurobonds

o The yield of Eurobonds would be 0.5 to 0.6 of a percentage point above German bunds.o Italy, for instance, would save up to four percent of its GDP. o The balance sheets of banks would receive an immediate boost.o The end of austerity

Issues with Solution #3o “Interest socialism.” o Who would issue them? Issuance could be centralized in a single agency or remain at the national level with co-ordination among the Eurozone members.o Who would repay?o Merkel not a fan. In 2012, at a party congress, she said no Eurobonds "as long as I live." Several members of parliament allegedly responded by saying: "We wish you a long life.”

Solution #4: Devaluationo Several types: External, internal, fiscal o Struggling Southern Rim economies regain their competitiveness.o Citroens can appear in Asia or Latin America.

Issues with Solution #4o External devaluation would extend Germany’s trade surplus with the rest of the world. o A weaker euro leads to a sell-off of Southern Rim countries bonds.o In internal devaluation, if wages and prices fall, nominal GDP could fall. Thus, the debt to GDP ratio grows.o The real value of the big outstanding sovereign and company debt in countries like Cyprus and Greece rises over time. o In fiscal devaluation the costs accrue mostly to the poor.

Solution #5: Short-term measureso Reduce the regulatory burden on business oAsk the question: who would want to start a business in Greece? In what sector?

o Make ERM2 criteria part of entry into the European UnionoNearly all potential entrants have unilaterally adopted the euro (Kosovo and

Montenegro), are in a currency board (Bosnia) or have a fixed exchange rate to the euro (Denmark, Macedonia).

o Create a legal option for exit from the Eurozone in the TreatyoSimilar to Article 50 on exit from the European Union: “Any Member State may

decide to withdraw from the Union in accordance with its own constitutional requirements.”

Solution #5: Long-term measures

o Educational reform, through vocational training, continuing educationo Pension reformo Dealing with youth unemploymento Southern Rim should learn from the BELLso Completing the banking union

Is Fiscal Union Needed in Europe?o No, if you have a good vetting mechanism at entry (ERM2 part of EU entry requirements), if the rules of the Fiscal Compact are strictly followed, and if there is a credible exit option.o Near impossible to establish since takes significant powers away from national parliaments.o Tax harmonization will reduce the possibility of convergence for eastern Europe.o Large fiscal transfers will reduce accountability and increase corruption.o Unelected Brussels bureaucrats will decide on investment prioritieso Example: nuclear power vs. green energy in the European Union