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Much Ado about EMU

Much Ado about EMU. Andrew K. Rose Berkeley, Haas. Beware Greeks Bearing Bonds. Sovereign default now inevitable Hopefully voluntary; otherwise “disorderly” Current Greek 10-yr bond >30% German ≈2% (US, UK, Japan too) Government Debt unsustainable (≈150% GDP) German ≈ 80%

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Much Ado about EMU

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

  2. Beware Greeks Bearing Bonds • Sovereign default now inevitable • Hopefully voluntary; otherwise “disorderly” • Current Greek 10-yr bond >30% • German ≈2% (US, UK, Japan 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” • 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 Andrew Rose, EMU

  4. 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

  5. Convergence Criteria, 1 • Institutions (easy) • Central bank independence • Inflation (easy) • CPI inflation within 1.5% of target; • Target is average inflation of three countries with lowest inflation • Interest Rates (easy) • Average long-term interest rates within 2% of target; • Target is average long-term interest rate of the three low-inflation countries Andrew Rose, EMU

  6. Convergence Criteria, 2 • Exchange Rates (easy) • Fixed Exchange Rates within “normal bounds” (15%!) • No realignment within last two years • Fiscal Positions: 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 Andrew Rose, EMU

  7. Stability (and Growth) Pact • EMU “Ins” should maintain deficits of less than 3% GDP 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

  8. Hence More Fiscal Austerity • Considerable pressure on Greece to raise taxes, cut spending (and exacerbate 3-yr recession) • Portugal, Spain, Ireland too • But … will this work? • The markets don’t think so • Most commentators agree with markets • Right way to approach the problem? Andrew Rose, EMU

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

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

  11. But if Two Regions have AsymmetricBusiness 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 Andrew Rose, EMU

  12. Possible Methods to Adjust (to Asymmetric Business Cycles) • Sharing risks via public sector (system of taxes and transfers) • Or via private sector (international cross-holdings of assets) • Factor mobility (unemployed workers move to places of high demand) Andrew Rose, EMU

  13. 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

  14. 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

  15. Competitiveness within EMU Andrew Rose, EMU

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

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