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Straining the Bond: Europe in Crisis Evening at the Fed December 2012 Mark A. Wynne

Straining the Bond: Europe in Crisis Evening at the Fed December 2012 Mark A. Wynne Vice President FRB Dallas Director Globalization & Monetary Policy Institute. Overview. The story so far… The (increasingly global) fallout Contagion from periphery to core

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Straining the Bond: Europe in Crisis Evening at the Fed December 2012 Mark A. Wynne

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

  2. 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?

  3. 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

  4. 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

  5. The story so far(10-year government interest rates) Jan 1, 1999 Euro launched Jan 1, 2001 Greece joins

  6. Greece: in depression Millions Bil. Ch. 2005 euros Aug 2012 UR: 25.4% Aug 2012 youth UR: 57.0% Employment GDP Note: Diamonds indicate OECD November 2012 forecasts. Dashed lines indicate OECD forecasts in June 2012.

  7. Gross government debt as a percentage of GDP Percent Greek budget report Oct. 31, 2012 Estimates Projections 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

  8. Ireland: life after austerity? Millions Bil. Ch. 2009 euros Peak-to-trough decline through 2011: 6.9% July 26, 2012: Ireland returns to financial markets for first time since September 2010 Peak-to-trough decline through 2011: 14.5% Sep 2012 UR: 15.1% Sep 2012 youth UR: 34.5% Employment GDP Note: Diamonds indicate OECD November 2012 forecasts. Dashed lines indicate OECD forecasts in June 2012.

  9. Portugal: further contraction expected Bil. Ch. 2006 euros Millions Peak-to-trough decline through 2011: 7.0% Peak-to-trough decline through 2011: 3.2% Sep 2012 UR: 15.7% Sep 2012 youth UR: 35.1% Employment GDP Note: Diamonds indicate OECD November 2012 forecasts. Dashed lines indicate OECD forecasts in June 2012.

  10. Spain: latest bailout request Millions Bil. Ch. 2008 euros Peak-to-trough decline through 2011: 3.7% Peak-to-trough decline through 2011: 11.1% Sep 2012 UR: 25.8% Sep 2012 youth UR: 54.2% Employment GDP Note: Diamonds indicate OECD November 2012 forecasts. Dashed lines indicate OECD forecasts in June 2012.

  11. OECD NEET Ratios, 15 to 24 Years Percent OECD = Organization for Economic Cooperation and Development NEET = not in education, employment, or training Source: OECD Employment Outlook 2012

  12. Housing booms and bustsResidential investment as a share of GDP U.S.

  13. Housing booms and bustsResidential investment as a share of GDP Nevada Arizona Florida U.S.

  14. Housing booms and bustsResidential investment as a share of GDP Ireland Nevada Spain Arizona Florida U.S.

  15. Germany PMI in contraction phase Index Services Composite Manufacturing

  16. Broader euro-area PMI also in negative territory Index Services Composite Manufacturing

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

  18. 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)

  19. German cross-border lendingNet Balance Bil. euros

  20. The story so far(10-year government interest rates) Jan 1, 1999 Euro launched Jan 1, 2001 Greece joins

  21. One-size-fits-all monetary policy:Euro & U.S. (Taylor rate range)

  22. Labor mobility a hindrance toa common monetary policy (Regional variation in unemployment rates)

  23. 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

  24. 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

  25. Deficits in peripheral European countries comparable to U.S. deficits Budget deficits as a share of GDP Percent

  26. Fiscal situation of Europe as a whole relatively sound Government debt as a share of GDP Percent U.S. Euro area Note: Diamonds indicate OECD forecasts.

  27. 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

  28. 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

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