Euro-zone in Crisis

1. Euro-zone in Crisis by Assaf Razin June 2012

2. Regional crises • Greece: a public sector that went out of control, with chronic budget deficit • Spain: a real estate bubble bursts • Ireland: banks that were not regulated got into trouble, debts were moved from the financial sector to the government • Italy: a crisis of growth, the government is not able to return debts because of high risk premia

3. Non-functioning European monetary system Since the Greek crisis of 2010: • The euro country leaders are meeting in 15 top conferences • 7 heads of governments were replaced • 3 rescue plans with little achievements Is this updated?

4. A lab experiment that failed • The euro system is a lab experiment that was not planned correctly: a monetary union with no fiscal-political union

5. Low inflation – what is the price? • The ECB was planned to run a monetary policy that will cause low inflation • What about growth and financial stability? • The inflation was kept low – not only due to the ECB efforts • Other states outside the euro also enjoyed low inflation during the last decade • Those that were not in the euro did not had to carry the extra costs

6. The European monetary system - history • The world wars and the cold war led to the economic and monetary European union: one market, one currency • 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 a larger free trade area • Providing for the mobility of labor and other aspects of an integrated European market for goods and services

7. The European monetary system A single currency means: • that all of the countries in the monetary union have the same monetary policy and the same basic interest rate • interest rates differing among borrowers only because of perceived differences in credit risk • 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

8. The Euro 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: bubbles, inflation, and in the aftermath of the bubbles and inflation

9. The Euro deal • 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.

10. The Euro deal • 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: • Households used the increased debt to finance a surge in home building and house prices • governments borrowed to finance budget deficits that accompanied larger social transfer programs

11. The Euro deal • 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 • The financial crisis was a “spark” that led to the burst of the credit bubble, and the interest rates jumped

12. The Euro deal • 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

13. Lack of balance • In the “north” – trade surplus • In the “south” – deficits • Large capital flows to the peripheral countries led to an increase in wages • The competitiveness of the peripheral countries relative to Germany was harmed

14. Competitiveness within the Euro-zone: 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 Repeating the previous slide

15. Capital inflows to Spain

16. Relative Price of Non-Tradables

17. “Internal” depreciation vs. “Real” Depreciation - Spain • Two ways to reduce costs in Spain: • Cut wages relative to other countries • Increase productivity relative to other countries • It is hard to improve productivity in times of depression • When the ECB keeps low inflation in Germany, there must be large reduction in wages in Spain • The inelasticity of wages increase unemployment 17

18. “Internal” depreciation vs. “Real” Depreciation – Ireland vs. Iceland 18

19. “Internal” depreciation vs. “Real” Depreciation – Ireland vs. Iceland Iceland recovered faster than Ireland after the crisis Iceland – depreciation without cutting nominal wages Depreciation increased exports, increased demand for goods, and narrowed unemployment In Ireland, without depreciation, the wage had to go down with the demand for goods The inelasticity of nominal wages increase unemployment, and prevented growth of exports 19

20. Milton Friedman (1953) The argument for flexible exchange rates is similar to the argument for “daylight saving time” (summer time) “Isn't it absurd to change the clock in summer when exactly the same result could be achieved by having each individual change his habits? … But obviously it is much simpler to change the clock that guides all than to have each individual separately change his pattern of reaction to the clock, even though all want to do so.” It is simpler to change a single price, the exchange rate, than to simultaneously change all the prices in the market 20

21. Speculators and a lender of last resort The ECB is not allowed to act as a lender of last resort The market “understands” that it can force monetary union countries’ sovereigns into default This can not be done in the UK The financial markets attach a much higher default risk on Spanish than on UK government bonds, even though they have similar debt / product ratios 21

22. Speculators and a lender of last resortUK vs. Spain 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 22

23. Speculators and a lender of last resortUK vs. Spain 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. 23

24. Speculators and a lender of last resortUK vs. Spain But in Spain, investors can precipitate a liquidity crisis that could force the government into default The capital flows from Spain is automatic in such a case Spain will go bankrupt because of the speculators, even if it was relatively stable before the attack 24

25. Debt Dynamics, UK vs. Spain 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. 25

26. Self fulfilling expectation Expectations for bankruptcy reduces the market value of government bonds and rises the returns The rise in the returns leads to a low growth The probability for bankruptcy rises, so the expectations are self fulfilling 26

27. Monetary and fiscal union: the US The US has a monetary and fiscal union Income in some states can be transferred to other states, using the federal budget In 1790 George Washington created the first federal government. Many states where bankrupted after the war with the British Empire Alexander Hamilton, the Secretary of the Treasury, replaced the states debt by one federal debt No “haircut” for bond holders 27

28. Monetary and fiscal union: the US After the union – Hamilton lays taxes to cover the debt In the US the order is: first a fiscal union, after that a monetary union In Europe – the other way around? 28

29. Strategies to deal with this situation The Eurozone leaders agreed in October 2011 that the banks should increase their capital ratios 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 The ECB is lends hundreds of billions of Euros, just like in the “Lehman moment” 3 years ago 29

30. The new European Financial Stability Facility האם לקרן הזו הכוונה בשקף 31 במצגת העברית? האם הנתונים על הגודל מעודכנים? Size: 1 trillion Euros Activation is conditional on taking on an austerity policy But the fund is relatively small Austerity policy rises the deficits in the short term, and reduce future growth 30

31. Should Greece leave 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 31

32. Should Greece leave the Euro? 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 32

33. Summing up A lack of European institutions that can prevent debt crisis and rescue defaulting governments if and when the crisis occurs, does not allow me to assume that the problem will disappear during the following years The current concerns is about a “Lehman moment” that will happen after some state will leave the Eurozone, and will cause a global financial crisis Processes of deleveraging, austerity policy, liquidity crisis and deflation is causing an ongoing recession that will continue during the following years 33

34. Summing up Lack of growth and no restoration of competitiveness will cause a negative debt dynamics in the “south” countries Exposure of non-European banks to European bonds will require an expansionary monetary policy in other OECD countries 34