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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. Crisis; what crisis?.

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After the economic crisis what lessons for the european union

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


Crisis what crisis
Crisis; what crisis? European Union

“Europe will be forged in crises, and will be the sum of the solutions adopted for those crises” Jean Monnet


What price solidarity
What price solidarity? European Union

“If this is the sort of club the euro is becoming, perhaps Germany should leave” Angela Merkel


A quantum leap in the governance of the eurozone
“A quantum leap in the governance of the European Unioneurozone”?

"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


Whose problem is it
Whose problem is it? European Union


The crisis and economic coordination
The Crisis and Economic Coordination European Union

  • 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?


Overview
Overview European Union

  • 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?


Stages of integration
Stages of Integration European Union

  • 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?)


Many europes
Many European UnionEuropes


Why monetary integration
Why monetary integration? European Union

  • 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?


Implications of monetary integration
Implications of monetary integration European Union

  • 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


Optimal currency area theory
Optimal Currency Area Theory European Union

  • 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?


Optimal currency area theory1
Optimal Currency Area Theory European Union

  • 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

???


Is the eu an oca
Is the EU an OCA? European Union

  • 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)


Eu convergence criteria
EU Convergence Criteria European Union

  • 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


Fiscal implications
Fiscal implications European Union

  • 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


The deficit bias problem
The deficit bias problem European Union

  • 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?


The onset of the crisis
The onset of the Crisis European Union

  • 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?


Warning signs
Warning signs European Union


Asset price bubbles
Asset price bubbles European Union


Asset price bubbles1
Asset price bubbles European Union

Source: European Commission


The credit crunch
The credit crunch European Union

Source: European Commission


Deteriorating public finances
Deteriorating public finances European Union

  • 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?



Europe s fiscal problems
Europe’s fiscal problems European Union

Deficit Debt

Source: European Commission


General government balance
General Government Balance European Union

Source: Data from European Commission


General government gross debt
General Government Gross Debt European Union

GR

IT

IRL

BE

FR

UK

GE

SP

Source: Data from European Commission


The consequences
The consequences European Union

  • 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


The sovereign debt problem
The sovereign debt problem European Union

Source: European Commission


29.87 European Union

7.26

2.26

2.29

3.69

6.70


Divergence in the eurozone
Divergence in the European UnionEurozone

But why were Belgium and Italy different from Portugal and Ireland, and why has the situation changed?

Source: European Commission


Real economy consequences
Real economy consequences European Union

  • 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



Trade and output
Trade and output European Union

Source: HM Treasury: Budget 2010


Growth change year on year
Growth (% change year on year) European Union

Source: Data from European Commission


Growth prospects
Growth prospects European Union

Source: European Commission


Real output costs
Real output costs European Union

Source: European Commission


Policy responses
Policy responses European Union

  • 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?


But in the end
But in the end….. European Union

there will have to be a meeting of minds


How flexible can i be
How flexible can I be? European Union

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”


Lessons
Lessons European Union

  • 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?


Conclusions
Conclusions European Union

  • 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?


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