After the economic crisis – what lessons for the European Union

1. After the economic crisis – what  lessons for the European Union Roger Vickerman Dean, Brussels School of International Studies University of Kent Global Skills Award Lecture 28 November 2011

2. Crisis; what crisis? “Europe will be forged in crises, and will be the sum of the solutions adopted for those crises” Jean Monnet

3. What price solidarity? “If this is the sort of club the euro is becoming, perhaps Germany should leave” Angela Merkel

4. “A quantum leap in the governance of the eurozone”? "We are certainly encouraging governments to go as far as possible in being commensurate to the challenges. This is true in all domains, quantitative as well as qualitative. More flexibility in their own capacity to contribute to ensuring that there is financial stability is important.” Jean-Claude Trichet

5. Whose problem is it?

6. The Crisis and Economic Coordination • Crisis shows need for international consensus and coordination • Has the EU failed to achieve this internally and externally? • Is the Stability and Growth Pact discredited? • Can the ESM and EFSF do any better? • Would completion of EMU with a fiscal as well as a monetary union help? • Are we back to the ‘one-size fits all’ problem? • Can we only have solidarity in the good times – when is the EU not a zero-sum game?

7. Overview • One EU or many? • Is the EU an Optimal Currency Area? • Why do the criteria for joining differ from the economic criteria? • Is the Eurozone in terminal decline? • Origins of the crisis • Flawed economics or flawed politics? • Crisis responses – why only superficial consensus? • Where should the UK stand in this?

8. Stages of Integration • The Free Trade Area • no tariff barriers • The Customs Union • FTA + Common External Tariff • The Common or Single Market • CU + Factor Mobility - Non-tariff barriers • Economic and Monetary Union • EU + monetary integration • Economic Union • EMU + harmonisation of economic policies • Total Integration • EMU + harmonisation + fiscal and social integration (implies political union?)

9. Many Europes

10. Why monetary integration? • Completing the Single Market • Currencies as non-tariff barriers • Transaction costs of exchange • Cost of hedging future currency expectations • Lack of transparency in prices • The Single Financial Market • Increased efficiency from a single financial sector • Common banking rules • Common interest rates to avoid market distortions • Effective macro-stabilisation policies • Exchange rates as response to asymmetric shocks • Can one interest rate suit all economic situations?

11. Implications of monetary integration • Monetary policy and exchange rate regime • Fixed exchange rate: no independent monetary policy: • money is endogenous • Flexible exchange rate: no effect of fiscal policy: • the exchange rate offsets fiscal policy effects • Thus - the inconsistent/impossible trinity Fixed exchange rate Early ERM Eurozone Full capital mobility Monetary policy autonomy Non Eurozone

12. Optimal Currency Area Theory • Basic question is about exchange rates • Flexible exchange rates • adjust to cope with asymmetric shocks • Fixed exchange rates • exchange rates cannot adjust to deal with asymmetric shocks/productivity differentials/inflation differentials • adjustment has to come through other markets • requires common monetary policy • thus output/employment adjusts • but adjustment less if certain criteria are met • what about fiscal policy?

13. Optimal Currency Area Theory • Six criteria for an OCA • Labour mobility (Mundell) • Product diversification (Kenen) • Openness (McKinnon) • Fiscal transfers • Homogeneity of preferences • Solidarity The scoresheet: NO YES YES NO MAYBE ???

14. Is the EU an OCA? • Insiders and outsiders • the converged, the converging and the unconverged • the EU may not be an OCA, but is a subset of the EU an OCA? • does this imply that some should go it alone (a multi-speed union), and does this matter? • is the cost of entry too great for some relative to the perceived benefits (e.g. Greece, Portugal) • does entry lead to uncontrollable problems (e.g. Ireland, Spain) • does the entry of others subvert economic advantage (e.g. Germany, Netherlands, Austria)

15. EU Convergence Criteria • The Maastricht Treaty convergence criteria: • the achievement of price stability – a low rate of inflation close to the best performing states (defined as being within 1½ per cent of the average of the three lowest); • sustainability of the government financial position – the government should not run a financial deficit greater than 3 per cent of GDP, and gross general government debt should be less than 60 per cent of GDP; • exchange rate stability – apparent by the observance of the normal fluctuation margins provided by the Exchange Rate Mechanism, for at least two years; and • durability of convergence – convergence of long-term interest rates (defined as being within 2 per cent of the average long-term interest rate of the three lowest inflation states). • Note how these ‘monetary’ criteria differ from the ‘real’ criteria of OCA theory

16. Fiscal implications • In Eurozone fiscal decisions left to national governments • But governments can ‘cheat’ on fiscal responsibilities – get round tight monetary policy by looser fiscal policy • Hence need for a mechanism to control cheating – Stability and Growth Pact • SGP has Excessive Deficit Procedure to ‘fine’ miscreants • But can EDP work effectively if: • Slow to initiate • Big countries can subvert it • Fines make the position of weaker economies even worse • Need for better early warning system – the ‘Cologne process’ – implies willingness to share plans

17. The deficit bias problem • Monetary and fiscal policy must be consistent • Should criteria be relaxed? • balance over cycle? • political and credibility implications • Fiscal indiscipline concerns financial markets: • raises borrowing costs • but markets can distinguish between countries (credit ratings affect risk premia) • More serious is the risk of default in one member country: • capital outflows and a weak Euro • pressure on other governments to help out • pressure on the ECB to help out • The ‘no-bailout’ clause • is that any longer credible?

18. The onset of the Crisis • The origins of the crisis • Financial markets and ‘sophisticated’ instruments • Toxic assets and asset price bubbles • Who was to blame? • How to respond • Tax cuts or increased expenditure? • On what? • Who has been more prudent? • Scale of public expenditure boost • Debt – and who holds it? • The collapse of world trade and confidence?

19. Warning signs

20. Asset price bubbles

21. Asset price bubbles Source: European Commission

22. The credit crunch Source: European Commission

23. Deteriorating public finances • Spending out of a downturn • Divergence in the Eurozone • Failure to accept collective responsibility? • The habitual debt offenders: Greece, Belgium, Italy • The new deficit offenders: UK, Ireland, Portugal, Spain • The prudent offenders: Germany, Netherlands, Austria • But it isn’t only governments to blame?

24. Debt composition and trends (% GDP)

26. Europe’s fiscal problems Deficit Debt Source: European Commission

27. General Government Balance Source: Data from European Commission

28. General Government Gross Debt GR IT IRL BE FR UK GE SP Source: Data from European Commission

29. The consequences • Unsustainable deficits imply excessive borrowing • Where borrowing is international has two consequences: • Raises cost of borrowing • Devalues currency • But in Eurozone no devaluation option so risk premium rises - interest rate spreads on sovereign debt • In Eurozone speculators lose power to gain from currency fluctuations, so speculate on debt: pick off weakest first and then move along the row of dominos • Note this is exactly what happened to the old Exchange Rate Mechanism in 1992 • But now net effect is to weaken entire currency • UK is partially protected as can still offer currency fluctuation option – but only up to a point

31. The sovereign debt problem Source: European Commission

32. 29.87 7.26 2.26 2.29 3.69 6.70

33. Divergence in the Eurozone But why were Belgium and Italy different from Portugal and Ireland, and why has the situation changed? Source: European Commission

36. Real economy consequences • But isn't this just about money and government debts? • The output costs • Less government expenditure • Higher borrowing costs • Reduced values of wealth • Affects growth and employment • Trade and growth

37. Growth in selected economies

38. Trade and output Source: HM Treasury: Budget 2010

39. Growth (% change year on year) Source: Data from European Commission

40. Growth prospects Source: European Commission

41. Real output costs Source: European Commission

42. Policy responses • Spotting the problem: • a question of timing • what problems – is it like before • can we resort to old solutions • Is this the real price of globalisation? • Who is to blame: deficits vs surpluses • Do bail-outs work? • Will a European Stability Mechanism work any better? • Can the EFSF be funded? • And is there any real appetite for a fiscal union, on whose terms?

43. But in the end….. there will have to be a meeting of minds

44. How flexible can I be? Merkel argues that short-term “financial” solutions – such as jointly guaranteed “Eurobonds”, or allowing the European Central Bank to intervene in sovereign bond markets – will not solve the fundamental problem of excessive debt in the Eurozone. “It is not a question of give and take. It is about a big step towards fiscal union”

45. Lessons • There are benefits, but also costs, to being outside the Eurozone - if outside should stay right outside? • UK felt benefits felt during boom years, but have these led to costs later? • Would Eurozone membership have protected UK from worst excesses and their consequences? • To what extent have the Euro (and the ECB) been a success, and by what criteria? • What about the behaviour of some members? • Could the ECB (and the European social model) have learned anything from the UK experience (and vice versa)? • What implications for those countries which aspired to Anglo-Saxon liberalism and were less able to withstand the pain of its readjustment – should there be a dash for Euro-protection?

46. Conclusions • Is this an economic problem, a policy problem or a (lack of) solidarity problem • If so who is to blame? • Is the cure worse than the disease? And for whom? • Is there a better alternative? • What about Europe in the world? • The China question?