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The Future of the Currency Union
Jeffrey Frankel
Harpel Professor of Capital Formation and Growth
The Challenges of the European Crisis
Academic Consultants Meeting, May 6, 2013
Board of Governors of the Federal Reserve System
Washington DC
Three structural drawbacks are built into the monetary union.
• (I) The competitiveness problem,
– which arises from the inability of members to devalue (& loosen money),
– thoroughly anticipated by “Optimum Currency Area” warnings.
– Example of the OCA problem: Ireland needed tighter monetary policy
than the ECB’s during 1999-2007, and needs looser today.
• (II) The fiscal problem, in particular, moral hazard,
– which arises from keeping fiscal policy primarily at the national level.
– It was well-anticipated by architects of Maastricht.
• Pushed by German taxpayers afraid they’d have to bail out Club Med,
• they produced Maastricht criteria, No Bailout Clause, SGP, & successors.
• All failed, from day 1, continuously up to today.
– Greece is the worst example.
• (III) The banking problem,
– which arises from keeping bank supervision at the national level.
– It received very little discussion at Maastricht.
Overviews: Shambaugh (2012) “The Euro’s Three Crises” & Lane (2012) "The European Sovereign Debt Crisis"
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(I) THE COMPETITIVENESS PROBLEM
During the euro’s first decade, wages & ULCs
rose faster in the periphery than in Germany.
During
2008-11 (only) a fraction of the
wage gap was reversed.
Figure 3:
Figure 4:
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Source, IMF/ECB via M.Wolf, FT 10/10/12
Huge current account deficits in periphery countries
up to 2007 were seen as benign reflections of
optimizing capital flows, instead of warning signals.
Figure 5:
Source: World Bank, PREM, 2012. Data from IMF WEO Database
Figure 6:
Source: Krugman. “Which Way to the Exit?” Brussels, 2012
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(II) THE FISCAL MORAL HAZARD PROBLEM
Periphery-countries’ interest rates
converged to Germany’s after they joined the euro
=> investors perceived no default risk.
Figure 1
Given the high debts, the ECB must have been seen as standing behind them.
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The Greek budget deficit in truth had never
come below the 3% of GDP ceiling. Nor did the debt/GDP
ratio (≈100%) ever decline in the direction of the 60% limit.
Figure 2
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Debt/GDP ratios have been rising sharply,
as high interest rates & declining GDP overpower
progress on reduction of primary budget deficits.
Via: World Bank, PREM, 2012
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“What changes would be required for a more stable currency union?”
Possible paths forward in the 3 areas of crisis
• (I) The competitiveness problem:
– bleak.
– It is the argument for Greece dropping out of the euro
• if it defaults anyway, thereby making the balance sheet problem moot.
– Otherwise, the periphery must tough out internal devaluations.
• (II) The fiscal problem:
– hardest of all.
– Germany is right about moral hazard (in LR),
but wrong about “expansionary fiscal contraction” (in SR).
• (III) The banking problem:
– Encouraging moves in 2012, toward a banking union.
• Unlike fiscal union, one can imagine Europeans having moved
to supra-national supervision even if not part of monetary union.
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As one could have predicted, fiscal contraction is contractionary
Source: P.Krugman, 10 May 2012, via R.Portes, May 2013.
Question: “Are comparisons with the United States useful?”
Yes. The US is a successful monetary union.
• (I) Regarding loss of monetary independence:
– Prospective € members did not satisfy OCA criteria
among themselves as well as the 50 American states do:
• trade, symmetry of shocks, labor mobility, market flexibility,
& countercyclical cross-state fiscal transfers.
• Endogenous change in these parameters has been insufficient.
• (II) Regarding moral hazard from states’ fiscal policy:
– The US federal government has bailed out no state since 1790
– and nobody expects it to do so now.
– How did the US vanquish state-level moral hazard?
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The secret US ingredient is especially relevant
for Merkel’s recent reforms to give enforceability
& credibility to the eurozone targets for deficits & debt,
after the repeated earlier failures of the SGP.
• The Fiscal Compact is technically in effect, as of January 2013.
• It sets deficit targets stricter than the SGP,
• though at least they are specified in cyclically adjusted terms.
• Countries must put the euro-wide targets into their national laws.
• As rationale, some point to fiscal rules among the 50 states.
– Do they explain the absence of moral hazard in the US?
– Or is it the way spreads on the debts of spendthrift states rise,
• long before debt/income ratios reach anything like European levels?
– The fundamental explanation: The decision to let 8 states default
in 1841-42 rather than bail them out was a critical precedent.
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The EU leaders should have reacted to the Greek debt crisis
as Washington reacted to the southern states’ crisis in 1841.
• When the crisis erupted in Athens in late 2009, Frankfurt
& Brussels should have seen it as a golden opportunity.
• They already knew their attempted fiscal constraints had failed.
– So even the leaders must have known that sometime during the euro’s life
it would be challenged by debt troubles among one or more members.
– It was important to get the first case right, to set the correct precedent.
• Greece was the ideal test case, for two reasons:
– 1) Unlike Ireland or Spain, it was egregiously at fault,
• a natural place to draw a line, its creditors the natural ones to suffer losses.
– 2) Unlike Italy, it was small enough that other governments and systemically
important banks could have been protected from the consequences of a default,
• at a fraction of the cost of the EFSF, ESM, etc.
• In early 2010 the EC & ECB should have urged Greece
to go to the IMF and, if necessary, to restructure its debts,
– rather than calling this course “unthinkable.”
– The odds of containing the fire would have been far better than later.
Frankel, “The Greek debt crisis: The ECB’s three big mistakes,” VoxEU, May 16, 2011.
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Question: “In the current environment, how should
monetary policy operate given…such diverse shocks?”
• The ECB should follow an easier monetary policy
– than it generally has in the last 4 years.
• => higher inflation rates & depreciation.
• Will help Club Med improve its relative price competitiveness.
• German horror is understandable;
– they are entitled to their “morality tale.”
• But if the euro is to survive, the Germans must give way on some
things that they very deliberately did not sign up for at the start.
– They especially must give way on the absurd premise that
austerity is expansionary, as if we learned nothing from the 1930s.
• The ECB has already moved in the right direction under Draghi,
– LTROs & OMTs.
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Question: “Can the monetary union be achieved in the long run
without a significant increase in fiscal unity?”
No. “More Europe” is now inescapable.
In the medium run, debt/GDP ratios
must be put back on a sustainable path
through write-downs of “legacy debt,” “re-profiling,”
financial repression, bank bailouts, EFSF, ESM, ECB, etc.
Question: “Is fiscal unity politically possible?”
Full fiscal union? No.
The German taxpayers who were afraid that the euro would
lead to a fiscal bailout were proven right
(and the elites proven wrong). Why should they believe
that there will be no future bailouts?
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Addendum:
Two ideas to help restore LR credibility to fiscal rules
(after eliminating legacy debt overhang)
• Problem:
No version of the SGP or Fiscal Compact
has come up with a way to prevent national
authorities from making overly optimistic budget
forecasts ex ante and then, when exceeding the
caps ex post, saying it was beyond their control.
Who gets put in jail?
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Addressing the ex ante problem
• Officials in most advanced countries make overly
optimistic forecasts of growth and budgets. 1/
• Particularly in euroland:
– When today’s budget exceeds 3% of GDP,
the authorities adjust their forecasts, not their policies. 2/
• Solution: delegate the authority to forecast GDP and
budgets to independent expert councils or agencies. 3/
1/ Frankel, 2011, “Over-optimism in Forecasts by Official Budget Agencies and Its Implications," Oxford Review of Economic Policy, 27, no.4. NBER WP 17239.
2/ Frankel & Schreger; 2013, "Over-optimistic Official Forecasts in the Eurozone and Fiscal Rules," Review of World Economy, no.2 (Kiel). NBER WP 18283.
3/ Frankel, 2012, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” Central Bank of Chile and NBER WP 16945.
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Frankel & Schreger (2013)
In the euro countries, which were subject to SGP rules,
the
optimism
bias is reflected
in the
practice
of never
In the
euro countries,
which are
subject
to SGP
rules,
forecasting
budget
> 3% ofofGDP.
the
optimismnext
bias year’s
is captured
bydeficit
the practice
never
forecasting next year’s budget deficit > 3% of GDP.
Private-sector forecasts surveyed by Consensus Forecasts
are free to forecast budget deficits > 3% of GDP.
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Addressing the ex post problem
• Eurobonds might play a useful role:
The world’s reserve holders crave an alternative to US T bills.
– But most existing Eurobond proposals imply a “transfer union,”
which Northern European taxpayers cannot be asked to support.
• The Eurobond version that might work goes under the name of
“blue bonds,” proposed by two economists at the think tank Bruegel.1/
• Only debt issued by national authorities below the 60% criteria
would receive eurozone backing & effectively become Eurobonds.
– These are the “blue bonds” that investors would view as safe.
– If a country issued debt > 60% threshold, the resulting “red bonds”
would lose eurozone backing; the issuer would be fully liable.
1/ Jacques Delpla & Jakob von Weizäcker “The Blue Bond Proposal,” Breugel, May 2010.
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Addressing the ex post problem, continued
• As I see it, private markets would judge whether a country was crossing
the 60% threshold, even before the final statistics were available, 2/
– and therefore whether a new default risk required an interest rate premium.
• The sovereign risk premium would operate -– much as it does among American states,
– and as it did in Italy, Greece and the others before they joined the euro.
• The point is that the mechanism would be truly automatic.
– Perhaps in borderline cases the judgment whether a country had truly
exceeded the limit would ultimately have to be made by a court.
– But private investors would act from moment to moment.
– Market interest rates would provide the missing automatic discipline.
• Thus compliance would not rely on Brussels bureaucrats,
– whose discretionary letters have proven toothless
• no matter how many exclamation points are put at the end.
2/ Frankel , 2012, “Could Eurobonds Be the Answer to the Euro Crisis?” VoxEU, June 2012.
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