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The Eurozone:
New and Old Problems of a
Currency Area
by
Professor Assaf Razin
Tel Aviv University and Cornell University
EBA Public Lecture
July 14, 2011
1
History
• The road to European monetary
integration went through the European
Monetary System (EMS).
• At the start 1979, 8 countries
participated.
• The EMS lasted until 1998.
• In 1992 though EMS went through a
crisis—UK and Italy left.
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Economic Motives for EMS
• By, fixing their exchange rate to the DM, a
country can add credibility to its attempt to
control inflation.
• Helps market integration
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Chronology
• On January 1, 1999, 11 members of the
European Union (EU) adopted a common
currency area. They have since joined by6
more EU members.
• The birth of the Euro resulted in a fixed
exchange rates between all EMU member
countries.
• EMU countries sacrificed sovereignty over
their monetary policy.
• Control of monetary policy in the Eurozone is
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in the hands of ECB
Mastricht Convergengence Criteria
• The country’s inflation rate in the year before
addmissions must be no more than 1’5
percent a year.
• The country must have maintained a stable
exchange rate within the ERM without
devaluaing its currency.
• The country must have a public sector deficit
no higher than 3 percent of GDP.
• The country must have public debt that it
below, or approaching the level of 60 percent
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of GDP.
But..
• The last two conditions are drastically
violated before the 2008 crisis, and more
so afterwards!
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Optimum Currency Area
• Pre-requisits are: A lot of Trade of one
member with others; High Labor
mobility;Fiscal Union
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Benefits and Costs
• Benefits of joining currency area—doing a
lot of trade with your neighbors
(McKinnon)
• Costs : sacrifice of an independent
monetary policy, needed for stabilization of
inflation/output/employment.
• Costs of joining a currency union—low
labor mobility (Mundell), lack of fiscal
union (Kenen); Unified central bank fails to
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work as a “lender of last resort”
Is a single currency area
absolutely essential?
• Counter examples:
• Canada, “closer to the USA than it is to
itself”.
• Sweden, closer to Germany than the
periphery of EMU member countries.
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Confronting the financial trilemma
Economic policy makers would like to
achieve three goals:
1. Make a country’s economy open to
international flows of capital;
2. Use monetary policy to stabilize
output/employment/inflation/financalmarkets;
3. Maintain Stability in the currency
exchange rate.
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A Rub..
If you pick two of these goals the inexorable
logic of economics forces you to forgo the
third.
• USA picked the first two: any American can
easily invest abroad; The FED sets
monetary policy. But the exchange rate is
flexible.
• China picked the last two: Central bank
maintain tight control over monetary policy;
Its currency is pegged; but Chinese citizens
cannot move their wealth abroad.
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Europe Chose a Third Way
• They eliminated all exchange rate
fluctuations within the Euro Zone.
• Capital is perfectly free to move.
• The cost: giving up the possibilities of
national monetary policy.
• The ECB sets interest rates for the entire
Euro Zone. But if one country, say Greece,
differs from that of of the Euro Zone, that
country no longer has its own monetary
policy to address national problems. It has no
central bank which can act as a “lender of
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last resort”.
The Euro project as extreme
• The Euro project represent an extreme
solution to the tri-lemma:
• Absolute exchange rate stability
• Absolute openness to financial trade
• But
• Absolutely no sovereign monetary
authority
• And… No meaningful fiscal union!
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Euro as a straight jacket
• 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.
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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.
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• Gaps in competitiveness within Euro-zone
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Successful “internal Depreciation”:
German unification
• For a decade after its reunification boom
turned sour in the mid-1990s, Germany
took bitter medicine, holding wages down
and boosting productivity. The result was
a steady erosion of the peripheral
countries’ competitiveness, especially
relative to Germany.
17
Ireland Debt Overhang
• The overhang of toxic debt accumulated after
a decade in which Irish banks borrowed in the
international wholesale markets to finance a
property development bubble.
• Following the burst of the bubble the
government committed 50 billion Euros-one
third of GDP-to fill the hole.
• Back in 2008 the government gave 100
percent guarantee to all bank deposit and to
most of their debt.
• By September and October 2010 ECB lent to
Irish banks one quarter of all ECB lending to
Eurozone banks.
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Ireland’s Banks Run
• Ireland borrowed massively to stop its run
- 70 percent of GDP, including $90 billion
from the European Union Loan, leaving
the country with similar debt-to-GDP as
Greece.
• By saving the banks, and their creditors,
the government “bankrupted” the country.
• Unemployment is 14 percent and output is
down by 10 percent.
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Fiscal Contraction in period of Low
Demand: Can Growth be Restored?
• When suffering
from a deleveraging
shock -- the economy will need support
until over-leveraged players have had
time to work down their debt.
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Eurozone Policy Issues
First
: How big is any required debt
restructuring?
Second : Who should bear the cost?
Finally, is restructuring enough?
Third
: Whether the currency union will
last in its current form.
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Debt to GDP ratios
• By 2014 the ratio of gross debt to gross
domestic product will have risen to 180
percent in Greece, 145 percent in Ireland
and 135 percent in Portugal. Spain’s
debt ratio is about 90 per cent of GDP in
2014
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Required Debt Reduction to
Regain Solvency
If these countries could borrow in private
markets at a gross debt ratio of 80 percent of
GDP. Then, the reduction in value of the rest
of the debt would need to be as much as 65
percent of GDP for Greece, 50 percent for
Ireland and 45 percent for Portugal.
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Solvency-Based Haircuts
The total “haircut” would be € 423 bn:
€ 224 bn for Greece, € 107 bn for Ireland
and €92bn for Portugal. (Martin Wolf)
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Market Spreads
Spreads on 10-year bonds over yields on
German Bunds are 1,340 basis points, or
13.4 percentage points, for Greece, 875
basis points for Ireland and 818 basis
points for Portugal.
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What If Private Creditor bears the
losses of Debt Restructuring?
If all the haircuts were to fall on private
creditors, their losses in 2014 would be
97 percent of their holdings of Greek
debt, 63 percent of their Irish debt and
60 percent of their Portuguese debt.
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How to manage a co-operative debt
restructuring?
How to achieve competitiveness and the
return to growth?
Some point to the success of Latvia in
managing its so-called internal devaluation.
But its GDP is 23 percent below its
pre-crisis peak.
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The problem facing Greece is a
potentially self-fulfilling prophecy of
default.
High interest rates will lead to an
intolerable debt-service burden and the
inevitability of default.
The prospect of default, in turn, will lead
inexorably to high interest rates.
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Many economists in academia have
called upon Greece to default, and
thereby force an involuntary
restructuring of its debts.
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But,…
Nobody can guarantee a managed
default in today’s global financial system.
Bank runs,
Contagion to other countries,
The triggering of credit default swaps,
Legal actions by hedge funds that buy up
cheap Greek bonds and then sue for
full repayments
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The best-case scenario is Greece is in fact
able to manage its debts only if debt
servicing is moderate, gradual and backed
by renewed economic growth
if a low interest rate (at the level of today’s
AAA sovereign borrowers) is locked into
place and repayments are stretched out
over 20 years.
Greece can succeed only if low rates are
locked into place
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But..
• The best-case scenario could arise
through a spontaneous and
self-confirming bout of optimism,
triggered by French-German cooperation
to significantly reduce Greece’s debt.
• Very unlikely!
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The Euro: how do you run a common
currency without a common government?
• The weak economies want low interest
rates, and wouldn't mind a bit of inflation;
but Germany is dead set on maintaining
price stability at all cost.
• Europe cannot deal with "asymmetric
shocks" the way the United States does,
by transferring workers from depressed
areas to prosperous ones
• The result is a financial crisis, as markets
discount the bonds of weaker European
governments.
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Spanish real estate bubble
• The bubble brought massive inflows of
capital; within Europe, Germany moved
into huge current account surplus while
Spain and other peripheral countries
moved into huge deficit.
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Capital Inflows into Spain
• These big capital inflows raised
demand for Spanish goods and
services, leading to substantially
higher inflation in Spain than in
Germany and other surplus countries.
• Both countries are on the euro, so the
divergence reflects a rise in Spain’s
relative prices.
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The aftermath of the housing bubble
When the bubble burst, it left Spain with much
reduced domestic demand, and highly
uncompetitive within the euro area thanks to
the rise in its prices and labor costs.
If Spain had had its own currency, that
currency might have appreciated during the
real estate boom, then depreciated when the
boom was over.
Since Spain does not have its own currency it
seems doomed to suffer years of grinding
deflation and high unemployment.
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Capital inflows to Spain
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Relative Price of Non-Tradables
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Where are Spain’s budget deficits
in all this?
Spain’s budget situation looked very
good during the boom years.
It is running huge deficits as a
consequence, not a cause, of the crisis:
Tax revenue has plunged, and the
government has spent some money
trying to alleviate unemployment.
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The Crash of 2008 and the rescue
of the banks
• In the absence of the “lender of last
resort” for the ECB, there is a risk to
the Euro when each member state
attempts to rescue the banks
independently.
• In the aftermath of the financial crisis
Spain, Greece, Italy, and Ireland
created huge budget deficits
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Investors trying to avoid risk create
more risk elsewhere
• The essence of the problem is that
investors who sell government bonds of
one country do not take into account the
spillover effects on other country bonds.
The problem of contagion is high in eurozone because of the intensive trade
between its members.
• By forcing early exit strategy in one
member state they also force other
member states to do so.
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Other Eurozone Imbalances
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Current Account Imbalances
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External vs. Internal Devaluation
The euro allowed these internal
imbalances to grow unchecked and
now stands in the way of a speedy
adjustment, because euro-area
countries whose wages are out of
whack with their peers’ cannot devalue.
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Euro breakup?
• No country can be forced off the Euro
against its will.
• No country would voluntarily abandon it
- the shock of leaving would outweighs
any advantage of life outside
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The monetary union now needs an
ambitious and comprehensive solution:
it should commit to a Brady plan for
Europe.
A debt swap with guarantees, based on
the policy that ended Latin America’s
debt crisis, is the best option. Brady
bonds, the USA guaranteed bonds in
the1980s
Latin
American
crisis,
resulted from the exchange of
commercial
bank
loans,
semi
defaulted, into new bonds.
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Brady bonds
• Brady bonds, the USA guaranteed
bonds in the1980s Latin American
crisis, resulted from the exchange of
commercial
bank
loans,
semi
defaulted, into new bonds.
• The Brady bonds have their principal
and two semi annual interest payments
collateralized by 30-year zero-coupon
bonds by high quality assets.
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More on the agenda
• Building Institutions for better fiscal
integration
• Redesigning the ECB as a “lender of
last resort”.
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Conclusion
• Euro integration process helped advance
Political Goals: France links to Germany;
West Europe links to East Europe
• But..
• The survival of the European monetary
experiment depends on its ability to help
countries reach their economic goals.
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• Policy makers should accept that private
bond holders have no incentive to
participate voluntarily in any debt roll
overs.
• When a 10-year bond yield go much
above 7 percent, the country run huge
budget deficits, and has accummuled
huge debts, public finance becomes too
expensive for countries seeking market
funding. They need Euro supported debt
reductions.
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