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Some Observations on the Euro Area Crisis

and the Ways Out

“Crisis in the Euro Area, the Economic and Monetary Union,

and the Future of the EU”

The Economic Development Foundation

Conference Hall in Levent, Istanbul.

25th January 2011

Francesco Paolo Mongelli

(ECB and Frankfurt JW Goethe University)

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Preamble, caveats, and disclaimer

I would like to thank Prof. Dr. Haluk Kabaalioglu of the Yeditepe University in Istanbul, and the Economic Development Foundation, for inviting me today.

I have been asked to speak about: 1) the causes of the crisis in some member states of the euro area, 2) how this affects the stability of the euro area as a whole, and 3) whether the measures which are being undertaken are sufficient to relieve the current situation.

Before I even start addressing these issues, a few caveats and disclaimers are in order:

• First, I will be speaking under my own responsibility and my views may not necessarily reflect those of the ECB:

• Second, I am not sure that I can competently address all these above issues, but I can try to offer some personal observations; and

• Third, our understanding of the factors behind the crisis and how they weighted on each country is still evolving: the remedies are also evolving; and the economic and financial conditions are also fluid. There are upward potentials but also still downside risks. Moreover, it will take time to see the results of the policies enacted by each euro area country, and for a new institutional framework to crystalize.

That’s why I will only offer some observations.

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My aim today is to… …. illustrate how the crisis – from which we are gradually emerging -- is the result of various factors, failings and misjudgements. In fact, the crisis lays at the intersection of diverse events, developments and choices. Some go back many decades.

Plan of my presentation

Part 1. Features of the European process of integration

Part 2. Why, when and with whom a monetary union?

Part 3. Why EMU? Which benefits to consumers and corporate sector?

Part 4. Twelve years with the euro (1): some achievements and some failings

Part 5. A full-blown systemic financial crisis […and then the sovereign crisis of the euro area]

Part 6. The remedies

Part 7. Some concluding observations

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Part 1. Features of the European Process of Integration

• The European path to economic and monetary union is unique in history, as it has been based principally on the concept of a single market shared by sovereign countries. Various institutions allowed the EU to work.

• This is quite different from most monetary unions in the past, in which the prior creation of a political union - a nation state - paved the way for economic and monetary integration.

• The following two pictures show that in the EU/euro area we are dealing with a functional process of integration that started with the founding of the European Coal and Steel Community (ECSC) in 1952 and was then followed up with the establishment of the European Economic Community with the Treaty of Rome in 1957.

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POLITICAL INTEGRATION

ECONOMIC INTEGRATION MONETARY INTEGRATION

Political Integration starting point

Economic and Monetary Integration

POLITICAL INTEGRATION

ECONOMIC INTEGRATION MONETARY INTEGRATION

Economic Integration starting point Economic Integration, then exerts pressure towards Monetary Integration, and also Political Integration

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The unfolding of European integration (1)

Bela Balassa (1961) suggested an index of institutional integration based on five main stages:

– In Stage 1 the EU 6 formed a Free Trade Area (FTA): i.e., an area where tariffs and quotas are abolished for imports from area members, which, however, retain national tariffs and quotas against third countries;

– In Stage 2 the EU 6 formed a Customs Union (CU): i.e., a free trade area setting up common tariffs and quotas (if any) for trade with non-members (since 1968);

– In Stage 3 the EU 6 formed a Common Market (CM): i.e., they abolished non-tariff barriers to trade (promoting the integration of product and service markets) as well as restrictions on factor movement (promoting the integration of capital and labour markets);

– In Stage 4 the EU 6 formed an Economic Union (EUN): i.e., a common market with a significant degree of co-ordination of national economic policies and/or harmonisation of relevant domestic laws; and

– In Stage 5 the EU 6 pursued Total Economic Integration (TEI) : i.e., an economic union with all relevant economic policies conducted at the supranational level (like the single monetary policy).

We proposed an index built by assigning “scores” to the level of integration recorded for each stage.

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An Index of Institutional Integration for the EU-6

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Sub-Index of Monetary and Financial Integration

Monetary Union (1999)

Common Market (1993)

EMS (1979)

CAP (1962)

Customs Union (1968)

Currency Convertibility

Monetary Union (1999)

Capital Market LiberalizationEMS (1979)

Overall Index of Integration

EMS (1979)

Notes and Coins

Overall Index of Integration

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Complete freedom for capital transactions

Increased co-operation

Free use of the ECU (European Currency Unit,

forerunner of the €)

Improvement of economic convergence

Start of preparatory work for Stage Three

Maastricht Treaty gets binding (on 7 Feb 92)

STAGE ONE - 1 Jul ‘90 Establishment of the European Monetary Institute

(EMI)

Ban on the granting of central bank credit to the public

sector

Increased co-ordination of monetary policies

Strengthening of economic convergence

National central banks become fully independent with price stability as their

primary objective

Preparatory work for Stage Three

STAGE TWO- 1 Jan ‘94

Irrevocable fixing of conversion rates

Introduction of the euro in 11 EU Member States

Foundation of the Eurosystem and transfer of responsibility

for the single monetary policy to the ECB

Entry into effect of the intra-EU exchange rate mechanism (ERM II)

Entry into force of the Stability and Growth Pact

STAGE THREE- 1 Jan ‘99

• The European path to integration has advanced for so long because it proved overall highly beneficial.

• Unknown perhaps to most founders of the EEC in 1957, many decades later an entirely new path towards economic and monetary union (EMU) surfaced

• But how could policy makers tell if a group of countries was ready? What were the reasons to pursue monetary integration? Moreover, given that EMU would not have relied on a full political union, which other conditions mattered?

• So the crucial issues became: why, when and with whom a monetary union? Plans had to be drawn, arrangements had to be made, and countries had to prepare along the following stages.

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Part 2. Why, when and with whom a monetary union?

A conceptual framework used to address these questions is the Optimum Currency Area (OCA) theory.

An OCA is an optimal geographical area for sharing a single currency. Optimality is defined in terms of

various properties reducing the usefulness of nominal exchange rate adjustments:

a. high price and wage flexibility within each country;

b. similar inflation rates in the medium-term;

b. high mobility of factors of production;

c. a high degree of economic openness;

d. high financial market integration;

e. significant diversification in production and consumption;

f. fiscal integration;

g. shared political will; and

h. overall correlation of incomes and similarity of shocks.

The founders of EMU placed strong emphasis on the achievement of price stability and a high degree of (nominal) economic convergence prior to the start of a currency union.

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OCA theory: has weaknesses and limitations… • Several OCA properties are difficult to measure… and evaluate against each other

• “Problem of inconclusiveness” and also a “problem of inconsistency”

• Difficult to find clear normative implications: no simple “OCA-test”

• 1960s-mid 1970s: weakening of analytical framework, and others.

…but we also saw a reassessment of monetary unions

• the lessons learned from 20 years with the European Monetary System. Keeping separate currencies (DM, Francs and Liras) while pegging their exchange rates was subject to periodic tensions. A “corner solution” could solve this dilemma. Also a defensive intent: to safeguard the EU Single Market.

• advancements in economic theory. Long-run ineffectiveness of monetary policy and no “fine-tuning”. Gaining low inflation credibility by ‘tying hands’ and establishing a monetary union with a firm “nominal anchor” country.

• Advancements in econometrics permitted to “operationalise” some OCA properties: e.g., studies on similarities of shocks and their transmission, plus comparisons of monetary transmission mechanisms

• Overall reassessment: association to a currency union is now deemed to generate fewer costs in terms of the loss of direct control over monetary policy and the exchange rate. There is also more emphasis on the benefits.

Thus, the balance of judgements shifted in favour of monetary unions Fewer costs (in terms of the loss of direct control over policy tools), and more emphasis was cast on diverse micro and macro benefits.

Looking forward: “endogeneity of OCA”

The OCA theory was jolted by Rose and Frankel who showed that monetary unions lead to a significant deepening of reciprocal trade.

• The implications for the forthcoming euro area were substantial. EMU may turn into an OCA after the launch of the euro even if it was not an OCA before. “…countries which join EMU, no matter what their motivation may be, may satisfy OCA properties ex post even if they do not ex ante!”

• The perspective on the “why, when and with whom?” thus changed!

• The endogeneity emerges from a removal of a “barrier” like national monies.

• Trading and information costs are reduced enhancing price transparency discouraging price discrimination, thus, and reducing market segmentation and fostering competition.

• A single currency is seen as “a much more serious and durable commitment” it precludes future competitive devaluations

• Facilitates foreign direct investment within the monetary union and the building of long-term relationships.

The “endogeneity of OCA”may have weakened some residual resistances.

Part 3. Why EMU? Which benefits to consumers and corporate sector?

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Is there a way to represent these developments? A useful diagramme

Yes, by referring to the optimum currency area (OCA) theory. At its most basic level, the OCA theory is about openness, flexibility and correlation. Members of an OCA need to be:

• ‘Open’ vis-à-vis each other in terms of trade and financial integration. This reduces the usefulness of national exchange rates, spurs competition, improves the allocation of resources across the area and fosters growth.

• ‘Flexible’ in terms of price and wage flexibility, but also the mobility of capital and labour (both occupational and geographical). Flexibility enhances efficiency and also facilitates the adjustment following a shock.

• ‘Highly correlated’ with each other. This implies the absence of persistent and irremediable divergence over the medium to long term. Correlation is promoted by low and similar inflation rates, highly diversified production and consumption diluting the possible impact of country-specific shocks, broad similarity of policy preferences. Financial integration helps smoothing asymmetric shocks and spurs correlation as does fiscal discipline.

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Dynamics set in motion by monetary unions

OCA line

Extent of trade among members

of group (Openness)

Correlation of incomes

When the “Endogeneity” of OCA Dominates

EU

EMU1

2

3

Higher Flexibility

OCA line

Advantages of common currency dominate

Advantages of common currency dominate

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Why MUs? Which benefits to consumers and corporate sector?

A Benefits from price stability.

B Catalyzing economic integration and lowering cost of capital.

C Increasing risk-sharing.

D Raising efficiency.

E Lowering costs of conducting international transactions.

F Enhancing transparency and fostering competition.

G Support in the strengthening of adjustment mechanisms.

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Part 4. Twelve years with the euro (1): some achievements, but…

Price stability has been broadly achieved

• During 1999-2010 average CPI inflation has been about 1.97 percent.

• In almost every single member country inflation has never been as low as during these twelve years with the euro. Inflation expectations remained well anchored.

Growth

• Average real GDP growth was slightly higher in the euro area during 1999-2008 than in the previous decade. Real GDP per capita fared better. The growth performance varies from country to country. [Employm: 15 vs 3 1/2. Lab Mrkt part]

• Countries where growth has been disappointing obviously need to carry out structural reforms to revive their supply side.

Economic and financial integration

• Intra euro area trade in goods has increased from about 26% of GDP in 1998 to 33% of GDP in 2007. Intra-euro area trade in services has also gone up, from 5% to 7% of GDP.

• EMU seems to have been a magnet for FDI activities particularly in the manufacturing sector. Between 2000 and 2005 the euro area countries – either as recipients or as sources of investment – accounted for as much as 57% of world FDI flows.

International role of the euro

• The share of the euro in global foreign exchange reserves with a known currency composition increased during the first five years from around 18% to around 25%.

[Legacy of the crisis will be heavy but we still don’t know exactly]

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Part 4. Twelve years with the euro (2): ..there were failings

Despite several benign outcomes, we saw diverse failings that allowed various fault lines to build up over long periods namely:

• weak public finances in a group of countries,

• persistent imbalances in another overlapping group and

• slow productivity growth in some others.

The global financial crisis, whose epicentre seemed initially far away, has exposed and exacerbated these fault lines.

National failings of governance

• In some countries, economic governance did not fully rise to the challenges of a new, and rapidly changing, economic and financial environment.

• Underestimation of depth and implications of change in policy regime with the euro

• Benefits were taken, but policy efforts have been eschewed in several countries

• Yet, there was no lack of analysis and pressure from the ECB, the EU Commission and others

A failing of supranational monitoring

• Prior to the crisis there was an uneven enforcement of fiscal discipline over time and across countries.

• The preventive arm of the Stability and Growth Pact (SGP) didn’t work as hoped for.

• Since the launch of the euro, real exchange rates of euro area countries – i.e. their relative competitiveness – changed quite substantially (see HCI, ULC and CA deficits).

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What happened?• Gradual build-up of current account imbalances originating from a domestic credit boom in some

countries.

• Financial market-driven ‘exuberance’ fuelled a boom in real estate activities.

• At the same time, diverse manufacturing activities shrank, and jobs were lost.

• After the real estate bubble burst and the global financial crisis hit, fiscal policies became unsustainable.

How could these fault lines build-up for so long? There were weak deterrents.

• Multilateral surveillance failed. Various EU/euro area institutions did not have enough teeth to fully enforce the Stability and Growth Pact and push for and enforce more changes at national levels in November 2003, the SGP was even weakened.

• Financial market discipline was largely absent until well into the crisis 1st decade financial market participants and rating agencies did not discriminate between national issuers with different standings. No deterrant against excessive deficits and/or sustained high public indebtedness (that were however apparent). But, when the assessment changed about sovereign solvency, spreads soared as did premia on credit default swaps (CDSs).

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Part 5. A full-blown systemic financial crisis…

…. after Lehman Brothers bankruptcy in September 2008 money markets seized up.

• Unprecedented in size, if measured by financial losses and fiscal costs,

• Unprecedented in extent, if measured by its geographical reach, and

• Unprecedented in speed and synchronisation, if measured by the precipitous fall in worldwide economic output.

• International trade plummeted, which affected euro-area economies disproportionately due to their high degree of openness.

• The construction sector in many countries came to a standstill and unemployment climbed to levels not seen for decades.

• Budget deficits soared in all euro-area countries due to a drop in many sources of revenues, the expense of shoring up the economy, and the cost of various types of support to financial institutions.

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• When the Greek sovereign crisis intensified in late 2009 and early 2010, the disruptive potential of financial market backlash and threats of rapid contagion had not been fully grasped.

• Dysfunctional policy debate disaffection rose

• The governance of EMU was designed without a framework to deal with a sovereign crisis in the euro area.

• Why? As a deterrent to underpin the no-bailout rule, there was no facility for crisis management and resolution: but we found out the hard way that this deterrent didn’t work.

• Instead, a Medium-Term Financial Assistance facility is being used by diverse non-euro area EU countries. The current policy debate is mostly about how to fill this vacuum.

An observation: achievements and failings are interconnected… …but there was also an institutional vacuum

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0

0.5

1

1.5

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2.5

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3.5

4

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

GBP EUR USD

Sep. 2008:

Intensification of

crisis

Aug. 2007:

Origin of crisis

Dec.

2009:

Initiation

of

phasing-

out

Spring

2010:

Sovereign

debt crisis

Note: Spreads are the difference between 12-month Euribor/Libor and Overnight Index Swap rates in basis pointsSource: Bloomberg and ECB calculationsLatest observation: 08 December 2010

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Phase IV - Renditeabstände 10-jähriger Staatsanleihen ausgewählter Länder gegenüber dt. Bundesanleihen

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100

200

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600

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Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11

Greece Portugal Spain Italy Ireland

9 Aug 2007 7 May 20103 Dec 200915 Sep 2008

Beginning of the financial turbulence

Start of the sovereign debt crisis

Initiation of the temporary phasing out

Start of the global financial and economic

crisis

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Part 6. Some remedies The EU, and the euro area in particular, have responded to the crisis with various policy measures and arrangements, some of which are still being negotiated, including:

a. Financial consolidation accompanied by structural reform:

• All EU countries are reducing their budget deficits albeit at different paces as needed.

• This is being accompanied by structural reforms to improve growth and growth potential and support long-term fiscal sustainability implementation of the Europe 2020 strategy and National Reforms Programmes

b. Financial stabilisation: we now have the European Financial Stabilisation Mechanism (EFSM) and the European Financial Stability Facility (EFSF). In 2013 they will be replaced by a permanent European Stability Mechanism (ESM) that will lend but under strict conditionality.

c. Financial repair: The EU’s regulatory and supervisory framework has significantly strengthened (see next figure).

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The new supervisory framework in the EU

European Banking Authority

European Insurance andOccupational Pensions Authority

National supervisors (including supervisory colleges)

ECBNational

Supervisors(non-voting)National

central banks

EuropeanSupervisory

Authorities (ESA)

European Commission

Macro-prudential supervision

Micro-prudential supervision

European Systemic Risk Board

European System of Financial Supervision

President of the Economic and

Financial Committee(non-voting)

European Securities and Markets Authority

Issue risk warnings and, if necessary,Macro-prudential recommendations

Ensure EU-wide technical supervisory standardsCoordination of supervisors (also in crises)

E S

A

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…continued

d. Strengthening of economic governance framework: it will now focus on prevention and early correction. The EU aims at adopting the legislation by June 2011. Its main principles are:

• Strengthened fiscal surveillance: There will be a stronger focus on public debt. Also, national fiscal framework will be required to meet agreed minimum requirements;

• Broadened economic surveillance: A mechanism to identify and redress macroeconomic imbalances based on economic analysis and economic and financial indicators will be introduced, and

• Effective enforcement: A wider set of stricter enforcement mechanisms will increase incentives for compliance with EU rules and recommendations, making surveillance more effective.

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…continued

New instrument are being put in place to address possible risks of macroeconomic imbalances.

A three-steps procedure is now envisaged:

Step 1. The set up of an alert mechanism based on a number of indicators, complemented with qualitative analysis.

Step 2. If needed a further in-depth study will be conducted into the root causes (and potential dangers) from the imbalances.

Step 3. If policy distortions are identified, the country will be asked to take appropriate measures.

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Part 7. Some final observations • Sharing the euro has steadily transformed euro area economies that are now deeply interconnected.

This is generating largely benign effects that represent the intrinsic value of the euro area: it is a shared asset.

• Yet, such integration has provided the ground for the transmission of the sovereign crisis: through financial exposures, trade linkages and cross-country asset ownerships.

• While we had long understood the welfare costs of deferring structural reforms for too long, we now know that in a monetary union this may pose substantial risks to fiscal but also financial stability.

• Euro area countries need to more closely interpret domestic price development, relative costs of production and unit labour costs, export market shares, and productivity developments.

• This is reminiscent of the pegging of the nominal exchange rate of the past: it entails pegging real exchange rates.

• We note that the governance of the euro area has already turned around: yet this will take some time to ascertain.

• Deep at hearth there might still be a need for more clearly explaining what EMU can and cannot do, and conveying the rationale for its unique governance.

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Extra slides if needed

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Bibliography: • “The Transformational Impact of EMU and the Global Financial Crisis”

• http://www.ceps.eu/book/transformational-impact-emu-and-global-financial-crisis

• “On the benefits and costs of a monetary union”

• http://www.cepr.org/pubs/PolicyInsights/PolicyInsight46.pdf

• “Some observations on 'political' in EMU”

• http://www.cepr.org/pubs/PolicyInsights/PolicyInsight47.pdf

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…. with Catching Up by Spain, Portugal and Greece

EU-9 Spain Portugal Greece

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Note: Market rates are seasonally adjusted.Sources: Reuters, ECB, ConsensusLatest observation: December 2010

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2004 2005 2006 2007 2008 2009 2010 2011

5-year BEIR

5-year forward 5 years ahead BEIR

1-year forward 4 years ahead BEIR

6 to 10 years ahead Consensus inflation forecast

Long-term inflation expectations from SPF

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Other factors explaining the sharp trade contraction

• Precipitous drop in demand, exacerbated by confidence shock

• Firms’ de-stocking

• Structure of demand shock: tilted towards traded goods

• Financial constraints (“financing of trade” vs. trade finance)

• Disruptions to international supply chains

• (Quasi-)Protectionism

• [Freund (2009), Iacovone & Zavacka (2009)]

Global downturn

Trade elasticity higher during global downturns (4.7)

Financial crisis

Additional downward pressure on imports in affected countries

The contraction of trade flows is particularly severe in a “twin crisis”