Download So, what`s exactly going on in Europe?

Кризис Евро в исторической
перспективе:
предпосылки и последствия
Лекции по прикладным финансам в ЕУСПб
11 ноября 2011
Максим Буев
Европейский Университет в С.Петербурге
[email protected]
The Eurozone Crisis in a Historical
Perspective:
Its Preconditions and Consequences
EUSP Practitioner Lectures in Finance
11 November 2011
Maxim Bouev
European University at St.Petersburg
[email protected]
Outline

So, what’s exactly going on in Europe?

The main stylised facts and problems:
a) Europe, in particular
b) the modern (Western) economy, in general
Whence did Europe come: trade as an engine to
development on the continent

Monetary arrangements facilitating trade: a brief history of
the XX century


The Eurozone dilemmas

Solutions and resolutions

Perspectives: whither Europe and the World?
So, what’s exactly going on in Europe?

1999, Launch of the Euro:
“Inspiration for the € symbol came from the Greek letter
epsilon…crossed by two parallel lines to ‘certify’ the stability of
the euro.”
European Commission
So, € - ἒ ψιλόν, "simple e", united and stable Europe

Main ideas behind the EMU:
- reduce trading costs
- boost tourism
- streamline the economy
So, what’s exactly going on in Europe?
(continued)

What went wrong?
Most European governments run budget deficits: debt
burden has kept increasing over the past few years
So, what’s exactly going on in Europe?
(continued)

What went wrong?
Most European governments run budget deficits: debt
burden has kept increasing over the past few years
So, what’s exactly going on in Europe?
(continued)

What went wrong?
Debt in itself is fine, however, as long as markets BELIEVE that
countries and their governments can repay their debt.
If they stop believing they start demanding higher interest on
funds provided: new borrowing becomes difficult if at all possible!
As of a month ago, yields on 10 year gov. bonds:
Germany
France
Spain
Italy
Ireland
Portugal
Greece
2.05
2.83
4.95
5.56
7.41
10.80
22.14
%
%
%
%
%
%
%
Source: Bloomberg
So, what’s exactly going on in Europe?
(continued)

What went wrong?
If/when governments cannot borrow/service their debt they
start asking for emergency loans (IMF, EC):
Greece
€110 bn.
in May 2010
Ireland
€85 bn.
in November 2010
Portugal
€78 bn.
in May 2011
However, even emergency loans come with strings attached:
they need to be repaid!!....
BUT:
Total Greek debt
Greek debt per person
Average Greek salary in 2008
€340 bn.
€31,000
€25,915
Source: BBC/Eurostat
So, what’s exactly going on in Europe?
(continued)

What went wrong?
What if Greece can’t repay its debts and defaults?
So, what’s exactly going on in Europe?
(continued)

…well, a solution then is to kick the Greece out of the Eurozone, or is it?
However, as markets are driven inter alia by BELIEFs, Greece’s departure
might cause CONTAGION:
Portugal, Spain, Ireland, Italy, France would follow.
The END of the EURO.
Bye!
Stylised facts and problems
OK then, what have we learned from the situation so far?
paramount: economic trade drives unification of Europe
(hence the idea of no barriers, common currency, common policy, etc.)

for some reason nowadays the economic system works the way that
governments can borrow so much as to drive their economies to the brink
of a collapse…

…but the collapse, if happens, is closely linked to the behaviour of
markets, formation of BELIEFs and EXPECTATIONs, in other words, such
things as CONFIDENCE matter (cf ‘animal spirits’ of David Hume, 1739;
J.M. Keynes, 1936; George Akerlof and Robert Shiller, 2009; ‘multiple
equilibria’ and ‘self-fulfilling profecies’ of Alberto Alesina et al., 1989)

Whence did Europe come?
Let’s take an historical perspective…

trade in the XIX century: formation of the Gold Standard
Britain --> France --> United States --> Russia

the price-specie flow model
(David Hume, 1752; the Cunliffe Committee, BoE, 1919)



currencies linked to gold
capital freely flows around the world
FX rates are stable
Britain is in the centre of the world trade: managing BoP is EASY!
Balance of Payments, in broad sense:


Current Account + Capital Account + balancing term = 0

also important: peace (1870 - 1914) and international cooperation
Whence did Europe come?
(continued)
any deviation in trade in Hume’s model causes capital to flow, and put
FX rate under stress


then governments could NOT run deficits or had to
- debase currency (hidden, cf Reinhart and Rogoff, 2009)
- devalue currency (open)
- default (sometimes)
- deflate (usual option)
in practice, flows of capital automatically cause the economy to stabilise
before severe price deflation is needed

the system works the way that in the absence of parliamentary
democracy markets BELIEVE that governments are committed to the
stability of the exchange rates (Eichengreen, 2008)

Monetary arrangements facilitating trade

Gold standard and the Latin Monetary Union (1865 - 1927)
- no capital controls
- currency peg facilitates trade
- commitment to peg (fiscal and monetary policy)
- no political pressure
- CBs did not have to be the lender of last resort (LLR)
…and, btw, Greece was ejected in 1908 for forging/debasement of the
currency

WWI and free float of currencies (at the beginning of the 1920s)

Gold-exchange standard (1925 – 1936): it did not work because
- parliamentary democracy matters (unemployment is bad!)
- governmental commitment to the ccy peg is questionable
- markets updated their BELIEFs
- …while politicians did not!
- Britain is NO longer the centre of trade
- countries failed to cooperate on economic policies
Monetary arrangements facilitating trade
(continued)
Managed float of ccys (the 1930s), collapse of the international trade
and the WWII

Implementation of the Bretton-Woods Agreements (1944 - 1973) was
another attempt to re-construct the international trade as it was known at
the time of the Gold standard

- free trade (Current Account is open)
- no international capital mobility (Capital Account is closed)
- fixed FX rates

This system COULD work (for some time, that is) because
- as CA is closed governmental commitment to ccy peg was
plausible (cf the Impossible ‘Unholy’ Trinity in the MundellFleming model, i.e. IS-LM-BP, 1960s)
- monetary policy respected the ‘pressure of democracy’
- markets BELIEVEd that FX rates are to stay fixed
Monetary arrangements facilitating trade
(continued)

That (B-W) system could NOT work because
- liberalisation of trade / convertibility of the Current Account
lead to liberalisation of the Capital Account
- governmental commitment to ccy peg became not plausible
- CBs could no longer be the LLR
- markets no longer BELIEVE in ccy peg
Monetary arrangements facilitating trade
(continued)

Aftermath of the Bretton-Woods (since 1973)
- fully floating FX rates: big countries, somewhat self-dependent,
such as USA and Japan
- full pegs, currency boards: small economies,
such as Hong-Kong or Ecuador
- in between was Europe: collective adjustable pegs
‘the snake in the tunnel’
(based on Smithsonian Agreement 1971:
widening of B-W ccy bands from 1% to 2.25%)
‘the snake in the lake’
(abolition of ccy bands 1973 - 1978)
So what’s the matter with Europe?

“Because it’s there!” *, that is, geography matters
European countries wanted to avoid currency fluctuations, restore
currency pegs to facilitate trade in the region

However, the oil shocks in the 1970s made a transition to common
European currency not possible during that time

*)
a misquote from George Leigh Mallory, an Everest explorer of the 1920s
What does that all mean?
Interim summary
1. We have
- many countries that want to trade, remove barriers, stabilise capital flows
- capital flows freely, can be destabilising
- democracy, political parties (unemployment is bad!)
- trade is truly international (many centres)
- a country is stable in the long run if its BoP (broadly understood) is zero
2. Because of the Impossible Trinity and formation of market BELIEFs:
- EITHER currencies can be freely floating and then international cooperation is not
necessarily needed, BoP will be self-correcting and governments won’t be able to
run sustained deficits, CB can be the LRR
- OR currencies can be pegged, but then for the governments to run sustained
deficits correction of BoP is possible only through international cooperation
(integration, redistribution of surpluses), CB can’t be the LRR
The Eurozone
European Monetary System (1979 - 1991) was an attempt to
comprehend the failure of the Snake, find ways of stabilising flows of
capital, and move towards a full currency peg (the ecu was introduced)

EMS, however, collapsed because of the widening of the currency band,
inability to negotiate the necessary redistribution of surpluses, and a
failure to cooperate on the part of European central banks


Finally, the steps towards full liberalisation of trade in Europe
- common market (the Treaty of Rome, 1958)
- the vision of common monetary policy (Jacques Delors’ report
to the European Commision, 1989)
- the Maastricht Treaty (1991): 4 conditions on potential
members of the common-currency area

Introduction of the Euro (1999)
The problems with the Eurozone
But we do have the following problems here (of course!):
- the Eurozone introduced a fixed currency peg (monetary union), a
common monetary policy (European Central Bank), but forbade fiscal
transfers among the countries, while equipping them only with some rules
for fiscal prudency, which had been not properly honoured
- however, markets believe in the Unholy Trinity
- so, under the broad conditions of the Eurozone (democracy,
governments running budget deficits, ect) it all works fine until the
market (read – free flow of capital) decides to switch to German bonds
(Gary Lineker, a footballer: “Germany are Germany!”)
- under conditions of an economic crisis such a switch can be fatal
UNLESS there is a re-distribution of surpluses (cf USA, the failure of EMS)
The Eurozone dilemmas

Borrowers vs Lenders: Greece vs Germany

Austerity vs Growth: well, it’s a crisis, inn’it?
Discipline vs Solidarity: “learn the lesson or get out” vs “let’s help ‘em”
(cf redistribution of wealth between states in the USA)


Common Europe vs the Nations: looking fwd vs looking backward
(“Because it’s there!” – remember?)
Solutions and resolutions
Ok, now, the ECB is buying up Greeks and Italian bonds in the
secondary market (as direct transfer of money, i.e. buying in the primary
market, is not possible: ECB is independent, remember?)

EFSF and all that: insurance, Special Purpose Investment Vehicle
(SPIV), etc

The idea: calm down the markets, shift them back to good equilibrium
(cf Alberto Alesina et al., 1989)

But the fact of the matter: more integration is needed on the fiscal front
– common bonds, fiscal transfers (cf George Soros and Co)

Whither the mess?
Ok, then, for now there are the three likely scenarios
(the following I reproduce from the BBC website)…
Scenario I
“Countries muddle through”
Leaders introduce measures on a
gradual basis to try to contain the
problem
 Likely impact: uncertainty and risk
remain and the restoration of market
confidence is delayed
 The lack of confidence has a negative
effect on borrowing costs and growth,
not just in Greece and other Eurozone
countries, but elsewhere

Recession becomes a near certainty in Japan, Greece, Portugal, Italy
and Spain. The probability of a recession in the UK rises to about 70%

Scenario II
“Economy after economy defaults”
A default in one country, such as
Greece, forces other vulnerable Eurozone
economies to default
 Likely impact: once Greece defaults,
other countries become more likely to
default as investors become worried
about risks in the region
 Other European banks and pension
funds that hold large amounts of Greek
debt would also face losses

Portugal is the most likely next candidate for default. Other
vulnerable countries include Ireland, Spain and Italy
 Defaults by several Eurozone countries would make a generalised
banking crisis likely
 The end of the Euro….for the time being that is!

Scenario III
“Greece exits the Euro”
Allowing or forcing Greece to leave the
Eurozone
 Likely impact: Greek devaluation would
be certain - as investors would attach a
high risk to the country - and default
would be likely
 A run on Greek banks would follow,
meaning a collapse of the Greek financial
system
 International creditors would incur huge losses, Greek businesses
would go bust, and the Greek people would face high inflation
 Other possible consequences are mass emigration, especially of
skilled labour, towards other EU countries offering higher wages.
 There could also be new barriers to trade

References I
Ahamed L. (2009) Lords of Finance: The Bankers Who Broke the World
 Akerlof G., Shiller R. (2009) Animal Spirits: How Human Psychology
Drives the Economy, and Why It Matters for Global Capitalism
 Alesina A., Prati A., Tabellini G. (1989) Public Confidence and Debt
Management: A Model and A Case Study of Italy, CEPR Discussion Papers
351
 Eichengreen B. (2008) Globalizing Capital. A History of the
International Monetary System
 Hume D. (1739) A Treatise of Human Nature
 Hume D. (1752) On the Balance of Trade
 Keynes J.M. (1936) The General Theory of Employment, Interest and
Money
 Reinhart C., Rogoff K. (2009) This Time is Different: Eight Centuries of
Financial Folly

References II
RBS research
 Bloomberg
 Eurostat
 BBC
 Wikipedia
 Slon.ru

СПАСИБО!!!