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The Eurozone:New and Old Problems of

a Currency Area

EBA Public LectureJuly 14, 2011

by

Professor Assaf RazinTel Aviv University and Cornell

University

History

• The road to European monetary integration went through the European Monetary System (EMS).

• At the start 1979, 8 countries participated.

• The EMS lasted until 1998.

• In 1992 though EMS went through a crisis—UK and Italy left.

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Economic Motives for EMS

• By, fixing their exchange rate to the DM, a country can add credibility to its attempt to control inflation.

• Helps market integration

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Chronology• On January 1, 1999, 11 members of the

European Union (EU) adopted a common currency area. They have since joined by6 more EU members.

• The birth of the Euro resulted in a fixed exchange rates between all EMU member countries.

• EMU countries sacrificed sovereignty over their monetary policy.

• Control of monetary policy in the Eurozone is in the hands of ECB

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Mastricht Convergengence Criteria

• The country’s inflation rate in the year before addmissions must be no more than 1’5 percent a year.

• The country must have maintained a stable exchange rate within the ERM without devaluaing its currency.

• The country must have a public sector deficit no higher than 3 percent of GDP.

• The country must have public debt that it below, or approaching the level of 60 percent of GDP.

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But..

• The last two conditions are drastically violated before the 2008 crisis, and more so afterwards!

Optimum Currency Area

• Pre-requisits are: A lot of Trade of one member with others; High Labor mobility;Fiscal Union

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Benefits and Costs

• Benefits of joining currency area—doing a lot of trade with your neighbors (McKinnon)

• Costs : sacrifice of an independent monetary policy, needed for stabilization of inflation/output/employment.

• Costs of joining a currency union—low labor mobility (Mundell), lack of fiscal union (Kenen); Unified central bank fails to work as a “lender of last resort” (DeGrauwe).

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Is a single currency area absolutely essential?

• Counter examples:

• Canada, “closer to the USA than it is to itself”.

• Sweden, closer to Germany than the periphery of EMU member countries.

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Confronting the financial trilemma

Economic policy makers would like to achieve three goals:

1.Make a country’s economy open to international flows of capital;

2.Use monetary policy to stabilize output/employment/inflation/financal-markets;

3.Maintain Stability in the currency exchange rate.

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A Rub.. If you pick two of these goals the inexorable

logic of economics forces you to forgo the third.• USA picked the first two: any American can

easily invest abroad; The FED sets monetary policy. But the exchange rate is flexible.

• China picked the last two: Central bank maintain tight control over monetary policy; Its currency is pegged; but Chinese citizens cannot move their wealth abroad.

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Europe Chose a Third Way• They eliminated all exchange rate fluctuations within

the Euro Zone.• Capital is perfectly free to move.• The cost: giving up the possibilities of national

monetary policy.• The ECB sets interest rates for the entire Euro Zone.

But if one country, say Greece, differs from that of of the Euro Zone, that country no longer has its own monetary policy to address national problems. It has no central bank which can act as a “lender of last resort”.

The Euro project as extreme

• The Euro project represent an extreme solution to the tri-lemma:

• Absolute exchange rate stability

• Absolute openness to financial trade

• But

• Absolutely no sovereign monetary authority

• And… No meaningful fiscal union!13

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Euro as a straight jacket

• The only way is to reduce costs, relative to countries inside and outside the currency area. Economists sometimes refer to this as a “real depreciation” or “internal devaluation”. That requires slower price and wage growth or faster productivity growth than elsewhere. Given today’s low inflation rates, it means outright declines in prices and wages.

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Competitiveness within the Euro-zone: decade and a half

before the crisis

• Greece, Ireland, Portugal and Spain lost

a lot of competitiveness:• Low interest rates led to a surge in

domestic demand. And sharp rises in real wages.

• Productivity growth was not vigorous enough to compensate.

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• Gaps in competitiveness within Euro-zone

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Successful “internal Depreciation”:

German unification• For a decade after its reunification

boom turned sour in the mid-1990s, Germany took bitter medicine, holding wages down and boosting productivity. The result was a steady erosion of the peripheral countries’ competitiveness, especially relative to Germany.

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Ireland Debt Overhang• The overhang of toxic debt accumulated after a

decade in which Irish banks borrowed in the international wholesale markets to finance a property development bubble.

• Following the burst of the bubble the government committed 50 billion Euros-one third of GDP-to fill the hole.

• Back in 2008 the government gave 100 percent guarantee to all bank deposit and to most of their debt.

• By September and October 2010 ECB lent to Irish banks one quarter of all ECB lending to Eurozone banks.

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Ireland’s Banks Run

• Ireland borrowed massively to stop its run - 70 percent of GDP, including $90 billion from the European Union Loan, leaving the country with similar debt-to-GDP as Greece.

• By saving the banks, and their creditors, the government “bankrupted” the country.

• Unemployment is 14 percent and output is down by 10 percent.

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Fiscal Contraction in period of Low Demand: Can Growth be

Restored?

• When suffering from a deleveraging shock -- the economy will need support until over-leveraged players have had time to work down their debt.

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Eurozone Policy Issues

First : How big is any required debt restructuring?

Second : Who should bear the cost? Finally, is restructuring

enough? Third : Whether the currency union will

last in its current form.

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Debt to GDP ratios

• By 2014 the ratio of gross debt to gross domestic product will have risen to 180 percent in Greece, 145 percent in Ireland and 135 percent in Portugal. Spain’s debt ratio is about 90 per cent of GDP in 2014

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Required Debt Reduction to Regain Solvency

If these countries could borrow in private markets at a gross debt ratio of 80 percent of GDP. Then, the reduction in value of the rest of the debt would need to be as much as 65 percent of GDP for Greece, 50 percent for Ireland and 45 percent for Portugal.

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Solvency-Based Haircuts

The total “haircut” would be € 423 bn: € 224 bn for Greece, € 107 bn for Ireland and €92bn for Portugal. (Martin Wolf)

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Market Spreads

Spreads on 10-year bonds over yields on German Bunds are 1,340 basis points, or 13.4 percentage points, for Greece, 875 basis points for Ireland and 818 basis points for Portugal.

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What If Private Creditor bears the losses of Debt

Restructuring?

If all the haircuts were to fall on private creditors, their losses in 2014 would be 97 percent of their holdings of Greek debt, 63 percent of their Irish debt and 60 percent of their Portuguese debt.

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How to manage a co-operative debt restructuring?How to achieve competitiveness and the return to growth?

Some point to the success of Latvia in managing its so-called internal devaluation. But its GDP is 23 percent below its pre-crisis peak.

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The problem facing Greece is a potentially self-fulfilling prophecy of default.

High interest rates will lead to an intolerable debt-service burden and the inevitability of default.

The prospect of default, in turn, will lead inexorably to high interest rates.

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Many economists in academia have called upon Greece to default, and thereby force an involuntary restructuring of its debts.

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But,…

Nobody can guarantee a managed default in today’s global financial system.

Bank runs,

Contagion to other countries,

The triggering of credit default swaps, Legal actions by hedge funds that buy up cheap Greek bonds and then sue for full repayments

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The best-case scenario is Greece is in fact able to manage its debts only if debt servicing is moderate, gradual and backed by renewed economic growth

if a low interest rate (at the level of today’s AAA sovereign borrowers) is locked into place and repayments are stretched out over 20 years.

Greece can succeed only if low rates are locked into place

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But..

• The best-case scenario could arise through a spontaneous and

self-confirming bout of optimism, triggered by French-German cooperation to significantly reduce Greece’s debt.

• Very unlikely!

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The Euro: how do you run a common currency without a

common government? • The weak economies want low interest

rates, and wouldn't mind a bit of inflation; but Germany is dead set on maintaining price stability at all cost.

• Europe cannot deal with "asymmetric shocks" the way the United States does, by transferring workers from depressed areas to prosperous ones

• The result is a financial crisis, as markets discount the bonds of weaker European governments.

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Spanish real estate bubble

• The bubble brought massive inflows of capital; within Europe, Germany moved into huge current account surplus while Spain and other peripheral countries moved into huge deficit.

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Capital Inflows into Spain

• These big capital inflows raised demand for Spanish goods and services, leading to substantially higher inflation in Spain than in Germany and other surplus countries.

• Both countries are on the euro, so the divergence reflects a rise in Spain’s relative prices.

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The aftermath of the housing bubble

When the bubble burst, it left Spain with much reduced domestic demand, and highly uncompetitive within the euro area thanks to the rise in its prices and labor costs.

If Spain had had its own currency, that currency might have appreciated during the real estate boom, then depreciated when the boom was over.

Since Spain does not have its own currency it seems doomed to suffer years of grinding deflation and high unemployment.

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Capital inflows to Spain

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Relative Price of Non-Tradables

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Where are Spain’s budget deficits in all this?

Spain’s budget situation looked very good during the boom years.

It is running huge deficits as a consequence, not a cause, of the crisis:

Tax revenue has plunged, and the government has spent some money trying to alleviate unemployment.

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The Crash of 2008 and the rescue of the banks

• In the absence of the “lender of last resort” for the ECB, there is a risk to the Euro when each member state attempts to rescue the banks independently.

• In the aftermath of the financial crisis Spain, Greece, Italy, and Ireland created huge budget deficits

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Investors trying to avoid risk create more risk elsewhere

• The essence of the problem is that investors who sell government bonds of one country do not take into account the spillover effects on other country bonds. The problem of contagion is high in euro-zone because of the intensive trade between its members.

• By forcing early exit strategy in one member state they also force other member states to do so.

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Other Eurozone Imbalances

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Current Account Imbalances

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External vs. Internal Devaluation

The euro allowed these internal imbalances to grow unchecked and now stands in the way of a speedy adjustment, because euro-area countries whose wages are out of whack with their peers’ cannot devalue.

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Euro breakup?

• No country can be forced off the Euro against its will.

• No country would voluntarily abandon it - the shock of leaving would outweighs any advantage of life outside

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The monetary union now needs an ambitious and comprehensive solution: it should commit to a Brady plan for Europe.

A debt swap with guarantees, based on the policy that ended Latin America’s debt crisis, is the best option. Brady bonds, the USA guaranteed bonds in the1980s Latin American crisis, resulted from the exchange of commercial bank loans, semi defaulted, into new bonds.

Brady bonds

• Brady bonds, the USA guaranteed bonds in the1980s Latin American crisis, resulted from the exchange of commercial bank loans, semi defaulted, into new bonds.

• The Brady bonds have their principal and two semi annual interest payments collateralized by 30-year zero-coupon bonds by high quality assets.

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More on the agenda

• Building Institutions for better fiscal integration

• Redesigning the ECB as a “lender of last resort”.

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Conclusion

• Euro integration process helped advance Political Goals: France links to Germany; West Europe links to East Europe

• But..

• The survival of the European monetary experiment depends on its ability to help countries reach their economic goals.

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• Policy makers should accept that private bond holders have no incentive to participate voluntarily in any debt roll overs.

• When a 10-year bond yield go much above 7 percent, the country run huge budget deficits, and has accummuled huge debts, public finance becomes too expensive for countries seeking market funding. They need Euro supported debt reductions.

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