Straining the Bond: Europe in Crisis Evening at the Fed December 2012 Mark A. Wynne Vice President FRB Dallas Director Globalization & Monetary Policy.

Straining the Bond: Europe in Crisis Evening at the Fed

December 2012Mark A. Wynne

Vice President FRB DallasDirector Globalization & Monetary Policy Institute

Overview

• The story so far…• The (increasingly global) fallout

– Contagion from periphery to core– Contagion to the rest of the world

• The fundamental challenges– Burned ships (the Cortes strategy)– The world’s greatest game of chicken

• Lessons from history• End game

– Move to a political union?– Or lost decade(s) à la Japan?

The euro crisis: a chronology

• May 2010: Greek bailout €110 bn• November 2010: Irish bailout €85 bn• April 2011: Portuguese bailout €78 bn• July 2011: Second Greek bailout €130 bn• December 2011: Fiscal compact agreed; ECB LTROs• April 2012: Greek default• Summer 2012

– Yields on Spanish government debt reach record highs– €100 bn bailout of Spanish banks– Yields on stronger sovereigns go negative on safe-haven flows– ECB cuts deposit rates to zero

• July 26: “…the euro is irreversible…. Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” – ECB President Mario Draghi

Major developments August-December 2012

• September – ECB announces plans to conduct Outright Monetary Transactions (OMTs) “…to safeguard

the monetary policy transmission mechanism in all countries of the euro area” and “…address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro”• One dissenting vote: Bundesbank President Weidmann

– German constitutional court rules that Germany can contribute to the European Stability Mechanism

– European Commission publishes proposals for a European banking union• Focus on bank supervision; issues of deposit insurance and bank resolution unaddressed

• October– S&P downgrades Spain to BBB-– European Union wins Nobel Peace Prize

• November– Third Greek “bailout”

• Lower interest rates & extended terms on loans; recycling of SMP profits back to Greece

The story so far(10-year government interest rates)

1990 1995 2000 2005 20100

5

10

15

20

25

30 Greece

Portugal

Spain

Ireland

Italy

Belgium

France

Austria

Netherlands

Finland

Germany

Percent

Jan 1, 1999Euro launched

Jan 1, 2001Greece joins

Greece: in depression

1999 2001 2003 2005 2007 2009 2011 20133400.0

3600.0

3800.0

4000.0

4200.0

4400.0

4600.0

100000

120000

140000

160000

180000

200000

220000Peak-to-trough decline through 2011: 10.2%

Peak-to-trough decline through 2011: 14.6%

Employment GDP

Millions Bil. Ch. 2005 euros

Aug 2012 UR: 25.4%Aug 2012 youth UR: 57.0%

Note: Diamonds indicate OECD November 2012 forecasts. Dashed lines indicate OECD forecasts in June 2012.

Gross government debt as a percentage of GDP

2009 2010 2011 2012 2013 2014 2015 2016100

120

140

160

180

200Greek budget report Oct. 31, 2012

IMF's World Economic Outlook October 2012

Review of bailout program March 2012 (Estimates overlap with 2012 IMF data for 2009-2011)

Original bailout program May 2010

Estimates Projections

Percent

Ireland: life after austerity?

1999 2001 2003 2005 2007 2009 2011 20131600.0

1800.0

2000.0

2200.0

100000

120000

140000

160000

180000Millions Bil. Ch. 2009 euros

Sep 2012 UR: 15.1%Sep 2012 youth UR: 34.5%

Peak-to-trough decline through 2011: 14.5%

Peak-to-trough decline through 2011: 6.9%

Note: Diamonds indicate OECD November 2012 forecasts. Dashed lines indicate OECD forecasts in June 2012.

July 26, 2012: Ireland returns to financial markets for first time since September 2010

Employment GDP

Portugal: further contraction expected

1999 2001 2003 2005 2007 2009 2011 20134400.0

4600.0

4800.0

5000.0

5200.0

145000

150000

155000

160000

165000

Sep 2012 UR: 15.7%Sep 2012 youth UR: 35.1%

Millions Bil. Ch. 2006 euros

Peak-to-trough decline through 2011: 7.0%

Peak-to-trough decline through 2011: 3.2%

Note: Diamonds indicate OECD November 2012 forecasts. Dashed lines indicate OECD forecasts in June 2012.

Employment GDP

Spain: latest bailout request

1999 2001 2003 2005 2007 2009 2011 201314000

15000

16000

17000

18000

19000

20000

21000

750000

825000

900000

975000

1050000

1125000Millions Bil. Ch. 2008 euros

Sep 2012 UR: 25.8%Sep 2012 youth UR: 54.2%

Peak-to-trough decline through 2011: 11.1%

Peak-to-trough decline through 2011: 3.7%

Note: Diamonds indicate OECD November 2012 forecasts. Dashed lines indicate OECD forecasts in June 2012.

Employment GDP

OECD NEET Ratios, 15 to 24 Years

Netherla

nds

Denmark

Iceland

Switzerla

nd

Sweden

Austria

Slovenia

Luxe

mbourg

Finland

Norway

Germany

Japan

Canada

Czech

Republic

Estonia

Poland

Australia

France

Portugal

Euro are

a 17EU27

Britain

Hungary

New ZealandUSA

Slovakia

BelgiumOECD

Ireland

Spain

Greece

Italy

Mexic

o

Turkey

-10-505

10152025303540

0.31.4 1.1 0.6

-0.1 -0.3

0.4 2.1 0.8 1.4 0.3 1.0

-4.1

1.0 0.4 1.7 1.9

-0.9

2.1 1.8 1.7 2.0 2.7 2.7 1.2 3.5 1.07.4 5.9 2.5

3.4

1.0

-8.1

Change Q1 2007 to Q1 2011Q1 2007Q1 2011

OECD = Organization for Economic Cooperation and DevelopmentNEET = not in education, employment, or trainingSource: OECD Employment Outlook 2012

Percent

Housing booms and bustsResidential investment as a share of GDP

1980 1985 1990 1995 2000 2005 20102

4

6

8

10

12

14Percent

U.S.

Housing booms and bustsResidential investment as a share of GDP

1980 1985 1990 1995 2000 2005 20102

4

6

8

10

12

14Percent

Arizona

U.S.

Florida

Nevada

Housing booms and bustsResidential investment as a share of GDP

1980 1985 1990 1995 2000 2005 20102

4

6

8

10

12

14Percent

ArizonaSpain

U.S.

Florida

Nevada

Ireland

Germany PMI in contraction phase

2005 2006 2007 2008 2009 2010 2011 201230

35

40

45

50

55

60

65

Expansion

Contraction

Index

ServicesComposite

Manufacturing

Broader euro-area PMI also in negative territory

2005 2006 2007 2008 2009 2010 2011 201230

35

40

45

50

55

60

65

Expansion

Contraction

Index

ServicesComposite

Manufacturing

Global falloutExports to the U.S. and euro area: share of world total

1980 1985 1990 1995 2000 2005 20106

8

10

12

14

16

18Percent

U.S.

Euro area

Global fallout

• United Kingdom– 50 percent of exports to euro area– “The greatest threat to the recovery stems from the risk that an

effective policy response is not implemented sufficiently promptly in the euro area” (Bank of England)

• China– EU is China’s largest export market, overtaking U.S. in 2007– “capricious development of the European debt crisis” as drag on

growth (People’s Bank of China)• United States

– 20 percent of exports to Europe– “…strains in global financial markets continue to pose significant

downside risks to the economic outlook” (FOMC)

German cross-border lendingNet Balance

1999 2001 2003 2005 2007 2009 20110

50

100

150

200

250

300

350

400

450

500

IrelandPortugalGreeceItalySpain

Bil. euros

The story so far(10-year government interest rates)

1990 1995 2000 2005 20100

5

10

15

20

25

30 Greece

Portugal

Spain

Ireland

Italy

Belgium

France

Austria

Netherlands

Finland

Germany

Percent

Jan 1, 1999Euro launched

Jan 1, 2001Greece joins

One-size-fits-all monetary policy:Euro & U.S.

1999 2001 2003 2005 2007 2009 2011-15

-10

-5

0

5

10

15

20

Euro area Taylor rate range

U.S. regions Taylor rate range

ECB policy rate

Federal funds rate

Percent

Euro area average range (1999-2011) = 10.6U.S. regions average range (1987-2011) = 5.2

(Taylor rate range)

Labor mobility a hindrance toa common monetary policy

1999 2001 2003 2005 2007 2009 20110

5

10

15

20

25

30

Euro area unemployment rangeU.S. regions unemployment range

Percent

Euro area average range (1999-2012) = 10.0U.S. regions average range (1999-2012) = 2.6

(Regional variation in unemployment rates)

Fixes

• Monetary union can exist without a fiscal union– But need rules to make it work– Tried and failed in Europe

• Fiscal & political union along U.S. lines– Tighter constraints on ability of member states to

run deficits– Pooling of regional risks, especially of banking

system risks

Lessons from history

• The United States in 1780s– Fiscal crisis associated with servicing debt incurred

during Revolutionary War• Solution: strengthen powers of federal

government (replace Articles of Confederation with U.S. Constitution)– Federal government assumed debts of states– One-time bailout: states allowed to default in 1840s– States adopted balanced budget rules thereafter

Deficits in peripheral European countries comparable to U.S. deficits

1999 2001 2003 2005 2007 2009 2011-14

-12

-10

-8

-6

-4

-2

0

2

4

Peripheral Europe: GDP-weighted fiscal balance

U.S.

PercentBudget deficits as a share of GDP

Fiscal situation of Europe as a whole relatively sound

1999 2001 2003 2005 2007 2009 2011 201330

40

50

60

70

80

90

100Percent

Note: Diamonds indicate OECD forecasts.

U.S.

Euro area

Government debt as a share of GDP

Disunion

• Declining trust in European institutions– Just 31 percent compared to 57 percent before

crisis• Less favorable image of the EU• Majority (52 percent) still support the single

currency– Down from 61 percent before crisis

Conclusions

• Euro crisis is spreading from the periphery to the core, and increasingly weighing on global economic activity

• LTROs of December 2011 and February 2012 have bought time– ECB rate reduction and possible revival of securities market program can ease strains– ECB is involved in a game of chicken with national governments

• OMTs will also buy time when implemented• New “fiscal compact”

– A significant improvement over earlier Stability and Growth Pact?– EMU 2.0 workable?

• Challenges– Achieving consensus on new rules: loss of sovereignty– Market rigidities – Austerity programs– Potential for social unrest

• Europe 1914