The Euro Area Crisis and Reforms Fiscal Discipline and Growth

André Sapir

Professor of Economics, Université Libre de BruxellesSenior Fellow, Bruegel

Two views about what went wrong and how to fix it

Diagnosis. The system was fundamentally flawed: a monetary union needs a political union

Remedy: “more Europe”

Diagnosis: The system was not fundamentally flawed: a monetary union among sovereign states can work, provided each state respects the rules

Remedy: “better Europe”

The original incompatible trio

You cannot have a situation with » Fixed exchange rates» Financial integration » Monetary autonomy

Financial integration was central in the arguments in favor of monetary union, yet its consequences for financial stability was largely ignored. No integration of financial policies.

The focus of Maastricht was on price stability. The ECB is a rare case of a CB NOT established in response to a banking crisis» The primary objective of the ESCB is to maintain price stability» The ESCB shall contribute to the stability of the financial system

Lesson from the crisis: the new incompatible trio

You cannot have a monetary union with» Financial stability» Financial integration » Inappropriate common fiscal and banking policies and institutions

Especially with important economic differences between countries

An important benchmark: The Swedish ‘90s crisis

Around the same time as Maastricht, Sweden suffered a major financial and then banking crisis

The Swedish response to the crisis is generally regarded as a model for other countries

The components of the Swedish strategy:» Comprehensive and rapid banking resolution» Supportive macroeconomic policies

Fiscal expansion => Next pagesMonetary expansion, including currency depreciation

» Structural reformsFiscal reformProduct market liberalizationLabor market and social reforms

6

Deficit-to-GDP ratio, 1985-2005

Source: Jonung (2009)

-3

7

Debt-to-GDP ratio, 1985-2013

Data source: AMECO February 2013

19851986

19871988

19891990

19911992

19931994

19951996

19971998

19992000

20012002

20032004

20052006

20072008

20092010

20112012

20130

20

40

60

80

100

120

140

SE

1996: 74%

1990: 41%

2000: 54%

8

Debt-to-GDP ratio, 1985-2013

Data source: AMECO February 2013

19851986

19871988

19891990

19911992

19931994

19951996

19971998

19992000

20012002

20032004

20052006

20072008

20092010

20112012

20130

20

40

60

80

100

120

140

EA12SE

9

Debt-to-GDP ratio, 1985-2013

Data source: AMECO February 2013

19851986

19871988

19891990

19911992

19931994

19951996

19971998

19992000

20012002

20032004

20052006

20072008

20092010

20112012

20130

20

40

60

80

100

120

140

EA12SEIT

The system failed

Prior to the crisis, surveillance was inadequate» It did not understand well the nature of the risks, including for BOP» Fiscal surveillance: SGP focus on deficit rather than debt» No EZ financial surveillance, inadequate national surveillance

Prior to the crisis, adjustment mechanisms were inadequate » The REER channel did not work well: divergences in competitiveness were not

corrected automatically or otherwise

When the crisis occurred, the system lacked adequate tools to deal with it

The system allowed huge imbalances

Very large current deficits

Huge build up of private and public debts, and external debts

Loss of competitiveness

The music stopped when the financial crisis started

12

Effect of EMU on external imbalances: Current account

Data source: AMECO May 2012

Correlation (GIIPS,DM)1960-1998: +0.28

19601962

19641966

19681970

19721974

19761978

19801982

19841986

19881990

19921994

19961998

20002002

20042006

20082010

2012

-8

-6

-4

-2

0

2

4

6

DMGIIPS

Correlation (GIIPS,DM)1999-2012: -0.73

13

Same for Germany and Greece

Data source: AMECO May 2012

Averages 1960-1998D = 0.9

GR = -0.9

Averages 1999-2012D = 3.7

GR = -12.1

19601963

19661969

19721975

19781981

19841987

19901993

19961999

20022005

20082011

-20

-15

-10

-5

0

5

10

DGR

14

Debt-to-GDP ratio, 1985-2013

15

Debt-to-GDP ratio, 1985-2013

16

Risk of sudden stop not understood before Lehmann

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17

Debt-to-GDP ratio, 1985-2013

18

Cumulative capital inflows in €A countries, 2002-12

Greece Portugal

Spain Italy

Sovereign debt crises possible (likely?) in € area

€ area governments issue debt in a foreign currency, just like in emerging countries!

What EA mechanism could have prevented such crisis?» Debt mutualization: replace national treasury by € area treasury» If no debt mutualization: strict rules to contain sovereign debts,

including rules on private debts

What EA mechanism could have lessened the effects the crisis? » If government solvent

ECB to act as LOLR ESM lending

» If government not solventEuropean Sovereign Debt Resolution Mechanism Debt redemption mechanism

The response: A Swedish strategy was not feasible

Comprehensive and rapid banking resolution: Impossible, no FDIC.

Supportive macroeconomic policiesFiscal expansion: Impossible because debt levels were already high and

danger of sovereign debt crisis => fiscal austerity, but self-defeatingMonetary expansion, including currency depreciation: Impossible

Structural reforms: difficult w/t supportive macro policiesFiscal reformProduct market liberalizationLabor market and social reforms

=> Limits of a “currency without a state” in a crisis situation

What then was the € area strategy?

Central role of the ECB, but limitations due to absence of a euro sovereign (TPS again: “the loneliness of the ECB”)

Banking: each country responsible for his own situation. Future: creation of a banking union, but w/t FDIC?

Supportive macroeconomic policies: Not muchFiscal expansion: austerity in deficit countries albeit with EU-IMF

assistance; but no expansion in surplus countries Monetary expansion: slow internal devaluation, but external value of

the euro remains high

Structural reforms: difficult w/t supportive macro policiesFiscal reformProduct market liberalizationLabor market and social reforms

=> No real strategy, besides “putting one’s house in order” with some assistance

22

Growing surplus/deficit country divide

Unemployment

Deficit countries have two problems

Obsolete socio-economic model already prior to joining the euro due to» Increased global competition from emerging countries» Increased competition within Europe from the NMS.

Model managed to survive thanks to euro adoption of the euro which permitted large net external debt positions, whereas the euro should have been an impetus for reform.

Now these countries have two problems» A competitiveness problem, not only intra-€A but also towards the NMS» An external debt problem

Twin problems of competitiveness and debt

Correcting the competitiveness problem requires lower prices in the periphery than in the core

But too low prices risk increasing the debt burden in the periphery by lowering nominal GDP

In addition austerity measures aimed at lowering public debt also lower nominal GDP

Hence correcting competitiveness and public debt risk creating self-defeating debt deflation in the peripheral countries

Austerity alone is not working

Are fiscal contractions expansionary? No, unless accompanied by other policies

Do fiscal contractions reduce deficits? Yes, but by less than 1

Source: Martin Wolf, FT 1/5/12

Note: a positive sign indicates a reduction in the

deficit.

26

Growing surplus/deficit country divide

The incompatible trio: Reforms

1. Reduction of economic differences between MS in some areas: reforms of national policies (e.g. labor markets) and EU policies (e.g. Structural Funds)

2. Creation of common policies and institutions in some areas: a banking and (?) fiscal union

Two big question marks

It’s relatively easy to design the LT solution, involving economic convergence and the build up of a banking and fiscal union based on a strong political commitment (“A genuine EMU”)

But two big questions about how to get from here to there» Are the existing economic, social and political differences between EZ MS

really compatible with a commitment in favor of banking and fiscal union?» Is there sufficient political commitment not just for the LT vision but also

about how to deal with the twin legacy problems of Competitiveness and asymmetric adjustment (External) debt

leading to potentially unsustainable debt and social situations in the periphery?