2011 Annual Conference, Bretton Woods NH, April 10

1. Optimal Currency Areas & Governance: The Challenge of EuropeJeffrey FrankelHarpel Professor, Harvard University 2011 Annual Conference, Bretton Woods NH, April 10

2. The framework of Niels Thygesen’s paper • 1970 – The issues according to the original Optimum Currency Area theory • esp. Mundell & McKinnon. • 1990 – The issues as they appeared to those drafting the Maastricht Treaty (1991). • esp. the Delors Report(1989) & One Market, One Money(1990). • 2010 – The issues as they appear in light of recent developments, • esp. the sovereign debt crisis of the periphery. 2011: Is Europe making the right reforms in governance?

3. 1970 – The issues according to the original OCA theory • For the gains of a common currency to be worth the cost of giving up independent national monetary policies, the countries must have: • “Symmetry” (≡ high correlation of shocks) • Labor mobility (across both borders and jobs) • A system of fiscal transfers (countercyclically) • Openness (a high ratio of tradable goods to GDP). • The early concerns of many American skeptics: • Europe lacks most of these OCA requirements.

4. 1990 – The issues as they appeared to those drafting the Maastricht Treaty (1991). • “…the background had changed remarkably. The implicit advice from the OCA checklist seemed less relevant, partly because it was… [more] likely to evolve favorably after introducing a common currency than before.” • Some research seemed to validate this judgment: • Monetary unions boost trade a lot • Rose (2000): “One Money, One Market” • => Cyclical correlation rises in turn • Frankel & Rose (1997,98): “Endogeneity of the OCA Criteria” • vs. Eichengreen (1992) and Krugman (1993) . • Also, labor markets will be forced to become more flexible • Roubini…

5. 1991 emphasized new issues instead • Prof.Thygesen lists the desire to address $ instability, and some others. • I would, rather, point to the heart of the “Maastricht criteria:”ceilings on budget deficit(3%)& debt/GDP(60%). • Fiscal criteria had not appeared anywhere in OCA theory. • One might have said, rather, that loss of the national monetary instrument made a free fiscal instrument more important. • Some economists found them incomprehensible. • E.g. Buiter, Corsetti & Roubini (1993). • Some speculated on what the Germans’ real motivation was. • E.g., a golden fleece.

6. But the motivationfor the Maastricht fiscal criteria is clear • as for the No Bailout Clause • and the Stability & Growth Pact (1997): • Skeptical German taxpayers believed that, before the € was done, they would be asked to bail out profligate Mediterranean countries. • European elites adopted the fiscal rules to demonstrate that these fears were groundless.

7. After the euro came into existence • it became clear that the German taxpayers were right • and the European elites were wrong. • E.g., Greece, even on the distorted budget figures it submitted, never satisfied the 3% rule in any single year after joining. • The large countries violated the rule too. • SGP targets were “met” by overly optimistic forecasts. • SGP threats of penalty had zero credibility. • Yet each year the ostrich elites stuck their heads deeper & deeper into the sands.

8. 2010 – Lessons from the sovereigndebtcrisis • Thygesen: • Responsibility for financial stability cannot remain exclusively at the national level. • The same for fiscal stability. • I agree. • But I do not agree that the official responses have been the right ones. • I agree, rather, with Darvas, Pisani-Ferry & Sapir: • Officialdom has been “reactive rather than proactive,” • treating insolvency as illiquidity.

9. Revisions in EMU governance • Fiscal rules “will become more explicit and will be monitored more tightly.”… • Weaknesses in the SGP “are now being addressed.” • “Structuralreforms…willbemonitoredcloselybythe EC.” • EU-level supervision of financial institutions, & European Systemic Risk Board (ESRB). • Permanent European Stability Mechanism (ESM) for crisis bailouts. • “The loans to Greece in May 2010 and to Ireland…[were] regarded as constructive by most critics.”

10. My reaction • The ostriches have stuck their heads down in the sand so far that they have popped up on some other planet. • There is even less reason now to think the SGP will work than there was the first time around.

11. European elites’ mistakes in managing the Greek debt problem • Admission of Greece to the euroin the 1st place. • ECB acceptance of Greek bonds as collateral • despite high debt & deficits. • => investors charged near-zero spreads, • helped by artificial high credit ratings. • Failure to send Greece to the IMF in early 2010. • Refusal to think about the likely need for restructuring of the debt.

12. Spreads for Greece & other Mediterranean members of € were near zero, from joining until 2008 Council on Foreign Relations

13. Spreads help keep profligate US states in lineas we saw in Carl-Ludiwg Holtfrerich’s paper Yield tomaturity in % 13 Source: W.B. English, „Understanding the costs of sovereign default …,“ p. 269. as used by Holtfrerich (2011)

14. What alternative fiscal reforms, then? • taking as given that German taxpayers will not allow a fiscal union now more than ever. • Proposal: • The SGP should emulate Chile’s successful fiscal institutions (Frankel, 2011): • Phrase the budget target in structural terms. • Give responsibility for determining what is structural to an independent professional agency, to avoid forecast bias. • Penalty when a country misses its target: • The ECB then stops accepting its bonds as collateral. • => Sovereign spread rises, with true automaticity.

15. EMU Ostrich

16. References by the speaker • Over-optimism in Forecasts by Official Budget Agencies and Its Implications," Feb.2011, written for symposium on Economic Borders of the State in the Oxford Review of Economic Policy. • “A Solution to Fiscal Procyclicality:  The Structural Budget Institutions Pioneered by Chile,” forthcoming, Fiscal Policy and Macroeconomic Performance,  Series on Central Banking Analysis, and Economic Policies, 2011.  NBER WP 16945, April 2011. • "Let Greece Go to the IMF," Jeff Frankel’s blog, Feb.11, 2010. • “The Estimated Effects of the Euro on Trade:  Why are They Below Historical Evidence on Effects of Monetary Unions Among Smaller Countries?” in Europe and the Euro, edited byAlberto Alesina & Francesco Giavazzi (U. Chicago Press), 2010.    • "Comments on 'The euro: It can’t happen, It’s a bad idea, It won’t last. U.S. economists on the EMU, 1989-2002,' by L.Jonung & E.Drea," slides. Euro at 10: Reflections on American Views, ASSA meetings, San Francisco, Jan.2009. • "The UK Decision re EMU: Implications of Currency Blocs for Trade and Business Cycle Correlations,"in Submissions on EMU from Leading Academics(H.M. Treasury: London), 2003. • "The Endogeneity of the Optimum Currency Area Criterion" (with Andrew Rose), The Economic Journal, 108, no.449, July 1998. • “‘Excessive Deficits’: Sense and Nonsense in the Treaty of Maastricht; Comments on Buiter, Corsetti and Roubini,” Economic Policy,Vol.16, 1993.