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Much Ado about EMU Andrew K. Rose Berkeley, Haas Andrew Rose , EMU 1 Beware Greeks Bearing Bonds • Sovereign default now inevitable – Hopefully voluntary; otherwise “disorderly” • Current Greek 10-yr bond >30% – German ≈2% (US, UK, Japan too) • Government Debt unsustainable (≈150% GDP) – German ≈ 80% • Big government deficits (≈10% GDP) imply continuing deterioration – German ≈ 1% Andrew Rose, EMU 2 How Could This Happen? • Article 103 (“No Bail-Out”) Maastricht Treaty – “… neither the Community nor any Member State is liable for or can assume the commitments of any other Member State” • European Financial Stabilization Mechanism (EFSM) – EC funds (from EU budget) of €60 bn • European Financial Stability Facility (EFSF) – May 2010: to “safeguard financial stability in Europe” – Can issue €440 bn of bonds, guaranteed by members, to lend to members “in difficulty” who request help, s.t. EC, ECB, IMF (“troika”) conditionality – Greece requested and received rescue package from EU/IMF (€110 bn), May 2010 – Ireland and Portugal followed Andrew Rose, EMU 3 How Did We Get Here? • Important to Understand Membership Requirements for EMU • Five “Convergence Criteria” required for entry • To be applied by the “Council of Ministers” • Mostly Economic, but Highly Politicized Andrew Rose, EMU 4 Convergence Criteria, 1 1. Institutions (easy) – Central bank independence 2. Inflation (easy) – CPI inflation within 1.5% of target; – Target is average inflation of three countries with lowest inflation 3. Interest Rates (easy) – Average long-term interest rates within 2% of target; – Target is average long-term interest rate of the three low-inflation countries Andrew Rose, EMU 5 Convergence Criteria, 2 4. Exchange Rates (easy) – Fixed Exchange Rates within “normal bounds” (15%!) – No realignment within last two years 5. Fiscal Positions: Sustainable Government Financial Position, defined as: a) Flow: Deficit/GDP ratio of less than 3%, and b) Stock: Debt/GDP ratio of less than 60% – “Escape clauses” exist for “temporary circumstances” or declining debt Andrew Rose, EMU 6 Stability (and Growth) Pact • EMU “Ins” should maintain deficits of less than 3% GDP or face penalties – German origins – Implies pro-cyclic fiscal policy (!) • Widely flouted by large countries in practice – France ‘03-’07, Germany ‘03-’06, Italy ‘03-? – Also breaches by Greece, Netherlands, Portugal – Reformed slightly in 2005 – Revived at summit in December 2011 Andrew Rose, EMU 7 Hence More Fiscal Austerity • Considerable pressure on Greece to raise taxes, cut spending (and exacerbate 3-yr recession) – Portugal, Spain, Ireland too • But … will this work? – The markets don’t think so – Most commentators agree with markets • Right way to approach the problem? Andrew Rose, EMU 8 How Should One Think about EMU? • Economists (and Haas students) usually ask two questions on EMU – “Do European Countries look like an ‘Optimum Currency Area’?” and – “Are European Countries similar to American Regions?” Andrew Rose, EMU 9 “Optimum Currency Areas” • Mundell’s Nobel Idea: When are two regions more likely to gain from common currency? 1. If they share deep trade links (single currency reduces transaction costs of trade) 2. If they have similar business cycles (same monetary policy appropriate) Andrew Rose, EMU 10 But if Two Regions have Asymmetric Business Cycles … • Need to be able to Adjust to “Asymmetric Shocks” (good for one region, bad for another) • Otherwise boom in one region causes inflation • Recession in other causes unemployment Andrew Rose, EMU 11 Possible Methods to Adjust (to Asymmetric Business Cycles) 1. Sharing risks via public sector (system of taxes and transfers) – Or via private sector (international cross-holdings of assets) 2. Factor mobility (unemployed workers move to places of high demand) Andrew Rose, EMU 12 Mundell’s “Optimum Currency Area” 1. Suppose business cycles are asymmetric, and 2. There is a) little risk-sharing, and b) immobile labor, then 3. Gain from using differential monetary policy to smooth different shocks • Use different monies to adjust to different business cycles • Evidence within countries (e.g., American regions) • Evidence across countries (e.g., EMU) Andrew Rose, EMU 13 Fiscal Austerity is not the Solution • It solves a different problem • Greek problem is poor competitiveness – Manifestations: current account deficit, slow growth, unemployment – Also true of other “Club Med” (Portugal …) • Classic example of “asymmetric shock” Andrew Rose, EMU 14 Competitiveness within EMU 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Real Effective Exchange Rate (1999=100) Germany 100.0 93.3 93.3 94.3 99.4 101.1 99.3 98.6 100.5 101.1 101.6 96.8 Greece 100.0 93.4 94.6 97.5 103.9 106.0 106.4 107.4 109.3 112.4 113.8 113.7 Portugal 100.0 97.6 100.0 102.5 107.2 108.5 108.5 109.1 110.8 111.7 110.9 108.6 Current Account Balance (% of GDP) Germany -1.3 -1.7 0.0 2.0 1.9 4.7 5.0 6.3 7.5 6.3 5.7 5.7 Greece -5.4 -7.8 -7.2 -6.5 -6.6 -5.9 -7.5 -11.2 -14.3 -14.8 -11.0 -10.6 Portugal -8.2 -10.4 -10.3 -8.2 -6.5 -8.4 -10.4 -10.7 -10.1 -12.6 -10.9 -9.9 Andrew Rose, EMU 15 Bottom Line • Greece has a fiscal problem – But solving it (if possible) won’t restore growth • Real problem: poor competitiveness limits growth, employment • No easy solution for that • Hence … more serious crisis inevitable – Could easily be worse than Lehman Andrew Rose, EMU 16