Rapporto Europa Adjusting to the crisis

1. Rapporto Europa Adjusting to the crisis 1

2. Table of Content Europe's adjustment to the crisis Exit strategies for what?  Public deficits and the sustainability of debt Private union bonds as an exit from the Greek drama Global imbalances: Europe’s role European economic governance. The Lisbon Treaty, the crisis and possible outlooks 2

3. Rapporto Europa 2010 • The world is coming out of its deepest economic crisis in 70 years, but the danger is not over. • Although economic growth has returned, it is weak. The European economy risks falling back into a «double-dip» recession, unless the restocking of inventory translates into sustained investment and job creation. 3

4. Rapporto Europa 2010 • Lessons from the Great Depression teach that an early recovery can revert back into recession, when bankruptcies, defaults, currency depreciations, and low assets prices undermine the creditworthiness of borrowers. • The Greek crisis risks to be precisely such an event • Falling bond and stock prices • Fiscal restraint • Weak euro 4

5. Europe's adjustment to the crisis 5

6. Rapporto Europa 2010 • The crisis has not only lowered growth, but also affected long term growth potential negatively • Investment • Employment • Euro Area is less affected than non-euro • Exception: Poland • Asia is least affected 6

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10. Rapporto Europa 2010 • Okun’s Law • claimed a dependable relation between employment and output. • Our estimate (table 3) shows Okun’s law for Europe • Given that the unemployment rate has risen from 6 to 9.5 percent in the crisis: • the European economy would have to grow 8.2 % in one year to return to the status quo ante • or 5.2 % over two years. • If it grows at the rate of 3 percent, it will take over 7 year to return to Unemployment rates of 2008 10

11. Rapporto Europa 2010 • Competitiveness distortions • The PIIG problem? • Current account balances vs unit labour cost levels? • Unit labour cost levels determine relative growth • Nominal wages relative to productivity • Degree of distortions measured by Variance 11

12. Rapporto Europa 2010 Levels of ULC Variance 12

13. Rapporto Europa 2010 • How did member states adjust? 13

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15. 2.  Exit strategies for what? 15

16. Rapporto Europa 2010 • Policy response to the crisis • Low interest rates and monetary easing • Fiscal stimulus packages • But when is it time to return to less accommodating policies? • Who should tighten first? • Monetary or fiscal policy? • Is there a danger of inflation? 16

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19. Rapporto Europa 2010 • Despite ample liquidity supply, money supply is not growing • No danger of inflation • Credit is not growing • But also: no growth • Danger of deflationary spiral? 19

20. Rapporto Europa 2010 • The interaction of monetary and fiscal policy • New issue after Greek bail-out and ECB buying government debt • Keynesian economics: stimulate demand • Ricardian economics: Not possible • Savings will increase to cover future tax liabilities • Government bonds are not net wealth 20

21. Rapporto Europa 2010 • If Central bank buys government debt, the tax liability of citizens is reduced • Seignorage • Government bonds are then net wealth because government spending increases income • Whether the economy is Keynesian or Ricardian depends on open market operations of Central bank 21

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24. Rapporto Europa 2010 • The optimal exit strategy • ECB buys government bonds • ECB controls price stability and money supply, possibly rising interest rates • Increases seignorage effects • Governments maintain fiscal stimulus • Until corporate sector is borrowing again • Like Obama 24

25. 3. Public deficits and the sustainability of debt 25

26. Rapporto Europa 2010 • Is fiscal policy out of control? • The Greek crisis • Excessive spending • Or reduced income due to crisis? 26

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31. Rapporto Europa 2010 • Is public debt in Europe sustainable? • Rising debt/GDP ratios • The concept of sustainability • A long term „steady state“ • Depends on fiscal policy objectives and growth rate • Convergence to the steady state • Fast or slow? • Depends on policy reaction function relative to growth adjusted real interest rate • (r-y)>α 31

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34. Rapporto Europa 2010 • Our estimates of the policy parameter • Growth adjusted interest rate (r-y) hardly ever exceeded 10% • Policy reaction to excessive deficit is well above these values: α • Italy: 20-24 % • Greece: 35 % • Spain: 28 % • Germany: 70-74 % • Denmark: 8-13 % 34

35. Rapporto Europa 2010 • Hence: public debt is sustainable in Europe • but the steady state rises significantly because of low growth • Need to accelerate growth is more urgent than cutting deficits • However, if debt is growing fast and there is need for refinancing, this could lead to illiquidity and default 35

36. 4. Private Union Bonds as an exit from the Greek drama 36

37. Rapporto Europa 2010 • On 9 May, Euro Area member states have set up a European Stabilisation Mechanism of € 750 bn • Subject to radical austerity packages • Is it sufficient? • Will it generate non-Keynesian growth effects? • Danger: overly hasty fiscal exit will push the European economy back into recession • What will happen to bail-out loans? 37

38. Rapporto Europa 2010 • The constitutional problem • Defaulting on bail-out loans is equivalent to “assuming a member state’s debt” • Forbidden by Lisbon Treaty § 123 • German constitutional court • The Transfer Union and moral hazard • A way to circumvent the problem: synthetic Union Bonds 38

39. Rapporto Europa 2010 • Private Union Bonds • Different from Tremonti’s proposal • A Fund or Trust buys government bonds of all Euro member states in proportion of ECB share capital • Issues Union Bonds in exchange • A portfolio of government debt • Les risk and volatility • Higher return 39

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43. Rapporto Europa 2010 • Private Union Bonds • Acceptable as paper for central bank operation • AAA • Ensures liquidity for banking system in case of default • Possibility to structure this product to give greater security to sovereign lenders and higher returns to risk taking private lenders • Overcomes the constitutional problem 43

44. 5. Global imbalances: Europe’s role 44

45. Rapporto Europa 2010 • The Greek crisis has accelerated the fall of the euro • Short term speculation? • Long term equilibrium: parity? • Economic stagnation in Europe • Accelerating growth in USA • High growth in Asia • This poses new difficulties and threats to the global economy 45

46. Rapporto Europa 2010 • Global imbalances were a major cause of the financial crisis • Low savings in USA • Consequence of bubble • High current account surpluses in Asia • Bernanke: Global savings glut • Europe in balance 46

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48. Rapporto Europa 2010 • Global imbalances reveal • Excessive US deficits of the Bush years are getting corrected by financial crisis • But structural US deficit remains • Euro Area is in balance • China will increase its surpluses • Who will absorb them? • Symbiotic relationship: USA-Asia 48

49. The three objectives for global adjustment • Reduce the American current account deficit • Prevent the crash of the Asian growth model • Avoid putting the burden of adjustment exclusively on the euro 49

50. Rapporto Europa 2010 • The transformation of the world economy • Elastic world labour supply due to globalisation • Unlimited supply of labour (Arthur Lewis) • China`s labour force: 25% of world and still growing • But slowing down and will stop in 2015 • Anchor for wage and price stability • Great Moderation • The new global growth pole is Asia 50