by Assaf Razin December, 2011

1. Creating the Monetary Union led to the current crisis, but breaking up the Euro would be difficult and costly by Assaf Razin December, 2011

2. The creation of the euro should now be recognized as an experiment that has led to the sovereign debt crisis in several countries, the fragile condition of major European banks, the high levels of unemployment, and the large trade deficits that now exist in most Eurozone countries. Although the European Central Bank managed the euro in a way that achieved a low rate of inflation, other countries both in Europe and elsewhere have also had a decade of low inflation without incurring the costs of a monetary union.

3. What led to Monetary Union The initial impetus that led to the European Monetary Union and the euro was actually political rather than economic. Political leaders generally favored the creation of the euro as a step toward deeper political integration. The shift of responsibility for monetary policy from national capitals to a single European Central Bank in Frankfurt would signal a shift of political power.

4. History The Treaty of Rome launched the Common Market in 1957. The Common Market developed into the European Economic Community in 1967 and the European Union in the Maastricht treaty of 1992, creating not only a larger free trade area but also providing for the mobility of labor and other aspects of an integrated European market for goods and services.

5. Monetary Union The political process evolved through the Maastricht Treaty’s creation of the European Monetary Union and the plans for the single currency which eventually began in 1999

6. A single currency means: • that all of the countries in the monetary union have the same monetary policy and the same basic interest rate, with interest rates differing among borrowers only because of perceived differences in credit risk. 2. A fixed exchange rate within the monetary union and the same exchange rate relative to all other currencies, even when individual countries in the monetary union would benefit from changes in relative values.

7. The Euro Deal As the euro became a done deal, countries that had previously had to pay a large interest premium found themselves able to borrow on the same terms as Germany; this translated into a big fall in their cost of capital. The result was bubbles, inflation, and in the aftermath of the bubbles and inflation.

8. When a county has its own monetary policy, it can respond to a decline in demand by lowering interest rates to stimulate economic activity. But the European Central Bank must make monetary policy based on the overall condition of all the countries in the monetary union. This means interest rates that are too high for those countries with rising unemployment and too low in other countries where wages are rising too rapidly.

9. The shift to a monetary union and the tough anti‐inflationary policy of the European Central Bank caused interest rates to fall in countries like Spain and Italy where expectations of high inflation had previously kept interest rates high. Households and governments in those countries responded to the low interest rates by increasing their borrowing, with households using the increased debt to finance a surge in home building and house prices while governments borrowed to finance budget deficits that accompanied larger social transfer programs. The result was rapidly rising ratios of public and private debt to GDP in several countries, including Italy, Greece, Spain and Ireland. Despite the increased risk to lenders that this implied, the global capital markets did not respond by raising interest rates on countries with rapidly rising debt levels.

10. A different market dynamic affected the relation between the commercial banks and the European governments. Since the banks were heavily invested in government bonds, the declining value of those bonds hurt the banks.

11. Sovereign Debt and Monetary Union • When entering a monetary union, member countries change the nature of their sovereign debt in a fundamental way. They cease to have control over the currency in which their debt is issued.

12. During the euro-bubble years there were huge capital flows to peripheral economies, leading to a sharp rise in their costs relative to Germany

13. Capital inflows to Spain

15. Now that the bubble bursts, should the adjustment be rising wages in Germany or falling wages in Spain? The ECB signals that no inflation in Germany will be tolerated. The recipe is for a prolonged slump in the periphery.

16. Fiscal Federalism • The transfer of economic resources from members with healthy economies to members who suffer economic setback can best be done through fiscal federalism—most of the risk is privately uninsurable. • This is a key difference between US and Eurozone. It remains to be seen whether the EU will develop more elaborate institutions for carrying out fiscal transfers among its members.

17. Iceland vs. Ireland Iceland’s positive swing has been about twice as large as Ireland’s — and we’re talking an extra 10 points of GDP here. That’s a lot of extra stimulus, and to the extent that it was due to devaluation, that’s a major plus for having your own currency

18. UK Government Bonds vs. Spain Government Bonds • Financial markets can force monetary union countries’ sovereigns into default. • The financial markets attach a much higher default risk on Spanish than on UK government bonds. In early 2011 this difference amounted to 200 basis points.

19. UK Government Bonds Suppose that investors fear that the UK government might be defaulting on its debt. They will sell their UK bonds, driving up the interest rate. After selling these bonds these investors would have pounds that they would want to get rid of by selling them in the foreign exchange market. The price of the pound would drop until somebody else would be willing to buy these bonds. UK money stock will remain unchanged.

20. Investors cannot precipitate liquidity crisis for a non sigle currency area country • Even if the UK government cannot find the funds to roll over its debt it would force the Bank of England to buy up the government securities. • Thus, investors cannot precipitate a liquidity crisis in the UK that could force the UK government into default.

21. Debt Dynamics: member of a single currency area and non member • UK—currency depreciation follows sovereign debt crisis and inflation increases. Real value of debt falls. • Spain—To regain competitiveness wages are cut following sovereign debt crisis. Deflation raises the real value of the debt.

22. “Internal” depreciation vs. “Real” Depreciation • The only way is to reduce costs, relative to countries inside and outside the currency area. Economists sometimes refer to this as a “real depreciation” or “internal devaluation”. That requires slower price and wage growth or faster productivity growth than elsewhere. Given today’s low inflation rates, it means outright declines in prices and wages.

23. Inflation in the “north” deflation in the “south” • Real exchange rate changes within a currency area come about with inflation in the “north” deflation in the “south”. But if the “north” pursue strict anti-inflation policy, deflation in the south is enhanced.

24. Competitiveness within the Euro-zone: decade and a half before the crisis • Greece, Ireland, Portugal and Spain lost a lot of competitiveness: • Low interest rates led to a surge in domestic demand. And sharp rises in real wages. • Productivity growth was not vigorous enough to compensate.

25. Debt crisis and fixed exchange rate: lessons from Latin America Argentina is a case in point. In 2001, it ran through a series of governments before triggering the world’s then-biggest default ($100bn; so small compared to Italy’s €1.9tn bond market).

26. To restore competitiveness without breaking Argentina’s euro-like currency peg, he engineered a “synthetic devaluation”. Across-the-board export subsidies and import duties came straight out of the textbooks, but didn’t work. Just as they often do in Europe today, investors saw the country’s debt dynamics still working against it.

27. Restoring competitiveness against bad debt dynamics To restore competitiveness without breaking Argentina’s euro-like currency peg, he engineered a “tax-based devaluation”. Across-the-board export subsidies and import duties came straight out of the textbooks, but didn’t work. Just as they often do in Europe today, investors saw the country’s debt dynamics still working against it.

28. Bad debt dynamics Default fears led to higher bond yields, which led to lower growth and smaller government revenues. This made default more likely in a process that soon became self-fulfilling. After three years of recession, much of southern Europe may already on the brinks of default.

29. Debt Deflation • The more wages and prices fall, the bigger debt burdens become in real terms. If the economy continues to there will be less money to service debts. But the more they lower wages and prices, the harder is the debt overhang burden is to bear. • Irving Fisher (80 years ago) notes that the struggle to reduce debts can sometimes increase indebtedness.

30. Expected length of current crisis • Long time before we can the crisis- European countries are expected to recover! • Problems are not going to go away soon for the European Monetary Union and the EU

31. Trends in Euro zone • Prolonged recession • Beyond Greece there will be more debt restructurings • Banks will be nationalized • ECB buys debt—price stability plays back role to financial stability

32. Three difficult-to-solve Problems • 1. Absence of adequate adjustment mechanism to correct current account imbalances among member states. Internal devaluation lead to currency mismatch on a member’s balance sheet. The result: Heavily indebted, uncompetitive, countries. • 2. Absence of bank regulation at the level of the union leads to race-t-the-bottom regulation competition among members.

33. 3. Inadequate supply of liquidity because national governments in the “south” have limited capacity to issue and redeem safe assets that can be bought and sold at predictable prices. The ECB is reluctant to be a lender of last resort to national governments.

34. Sovereign Debt And Banks By the fall of 2011, several European countries had debt to GDP ratios that made default a serious possibility. Sharp write‐downs in the value of their sovereign debt would do substantial damage to the European banks and possibly to banks and other financial institutions in the United States.

35. Strategies to deal with this situation 1. The Eurozone leaders agreed in October 2011 that the banks should increase their capital ratios and that the European Financial Stability Facility (EFSF) should be expanded from 400 billion euros to more than a trillion Euros to provide insurance guarantees that would allow Italy and potentially Spain to access the capital markets at reasonable interest rates.

36. 2. All 17 members of the Eurozone, plus 6 other countries who wish to join the Euro one day, signed in December 2011, an intergovernmental pact that would enforce stricter fiscal discipline. Sanctions will be imposed on countries that fail to stay with limits of budget deficits, inserting balance budget legislations of members, with the European Court in charge.

37. This plan to increase the banks’ capital won’t work because the banks don’t want to dilute current shareholders by seeking either private or public capital. Instead, they are reducing their lending, particularly to borrowers in other countries, causing a further slowdown in European economic activity.

38. 2. The second strategy calls for the European Central Bank to buy the bonds of Italy, Spain and other high debt to keep their interest rates low. The ECB has already been doing that to a limited extent but not enough to stop Greek and Italian rates from reaching unsustainable levels.

39. 3. The third strategy is favored by those who want to use this crisis to advance the development of a political union. They call initially for a “transfer union” or a fiscal union in which those countries with budget surpluses would transfer funds each year to the countries running budget deficits and trade deficits.

40. Greece The Greek budget deficit of 9 percent of GDP is too large to avoid a further outright default on its national debt. With a current debt to GDP ratio of 150 percent and the current value of Greece’s GDP falling in nominal euro terms at 4 percent, the debt ratio would rise in the next 12 months to 170 percent of GDP. Rolling over the debt as it comes due and paying higher interest rates on such debt would raise the total debt even more quickly. • even more quickly.

41. Cutting the interest bill in half by a 50 percent default while balancing the rest of the budget would only reduce the deficit very slowly, from 150 percent now to 145 percent after a year, even if no payments to bank depositors and other creditors were required. It is not clear that financial markets will wait while Greece walks along this fiscal tightrope to a sustainable debt ratio well below 100 percent.

42. Italy is much better Italy already has a primary budget surplus with tax revenue exceeding non‐interest government outlays by about one percent of GDP and a slightly positive rate of growth. With interest on the national debt now equal to about 5 percent of GDP, Italy’s total budget deficit is about four percent of GDP. A two percent of GDP reduction of that deficit would be enough to start a decline in the ratio of debt to GDP.

43. But this is not going to solve the competitiveness problem Reducing the problem of large budget deficits and the related problem of the commercial banks that have invested in government bonds would still not solve the long‐term competitiveness problem caused by monetary union.

44. Leaving the Euro? The alternative is for Greece to leave the Eurozone and return to its own currency. Although there is no provision in the Maastricht treaty for a country to leave, political leaders in Greece and other countries are no doubt considering that possibility for Greece. While Greece is currently receiving transfers from the other Eurozone countries, it is paying a very high price in terms of unemployment and social unrest for those transfers..

45. Bank crises in Greece? The primary practical problem of leaving the euro is that some Greek businesses and individuals have borrowed in Euros from banks outside Greece. Since those loans are not covered by Greek law, the Greek government cannot change the obligation from Euros to New Drachmas. • The decline in the New Drachma relative to the euro would make it much more expensive for the Greek debtors to repay those loans.

46. Strings attached But Germany is now prepared to subsidize Greece and other countries to sustain the euro, Greece and others might nevertheless decide to leave if the conditions imposed by Germany are deemed to be too painful to accept.

47. But breaking up the Monetary Union would be difficult and costly.

48. Ireland Boom Philip Lane of Trinity College notes: “There was a genuine Irish economic miracle, with very rapid output, employment and productivity growth during the 1994-2000 period.” Without entry into the eurozone, this might have petered out. But the fall in interest rates increased the risk that a credit-fuelled property bubble would emerge. So, indeed, it did.

49. Ireland Bust

50. The ratio of private credit to GDP jumped from around 100 per cent in 2000 to 230 per cent in 2008. Foreign lenders played a huge role in funding this boom: the net foreign liabilities of domestic banks went from 20 per cent of GDP in 2003 to over 70 per cent in early 2008. The global financial crisis caused an immediate cessation in the capital inflows. In panic-stricken response, the Irish government guaranteed bank debt in September 2008. As the fiscal costs mounted, driven by the slump and the need to rescue the banks, what began as a financial crisis ended up as a crisis in public debt.