Andrew Baker

What is wrong with the Euro Zone and what to do about it?

Break up messy and potentially catastrophic – need a better designed Euro zone.

1. The Macroeconomic design of the Euro zone

2. The history and politics of monetary union3. The financial crash of 2008 and the

response4. How to re-design the macroeconomic

framework

The macroeconomic design of the Euro-zone

Design is dysfunctional and even pathologicalWhat is a monetary union – what does it mean for

macroeconomic policy? States give up two macroeconomic policy

instruments and retain oneThe centralisation of interest rate policyIndividual Euro-zone countries have different

interest rate requirements at different parts of the cycle

Governments have lost a crucial macroeconomic policy instrument for steering economic activity in their jurisdiction

The macroeconomic design of the Euro-zone

Euro zone states have also lost the exchange rate as a policy lever

Only one macroeconomic policy lever remains at the national level – fiscal policy – making it extra important in a monetary union

24 January 2001 under article 99 (4) of TEC, the Commission asks ECOFIN to address a critical recommendation to Ireland for following procyclical budgetary policy

In a monetary union fiscal policy needs to perform a countercyclical role.

The macroeconomic design of the Euro-zone

Unfortunately fiscal policy frameworks in the Euro-zone overlook this basic insight

The SGP made a deficit-GDP ratio of 3% the centre piece – a questionable policy target in a monetary union?

The fiscal compact negotiated in 2012 – a tougher bolstered version of the SGP – but based on the same macroeconomic thinking and principles

A deficit-GDP ratio is inherently procyclical and can further amplify the procyclicality caused by interest rate and exchange rate centralisation

The history and politics of monetary union

European Monetary Union was a political project driven by particular political dynamics

It took place against the backdrop of German Unification in 1990

The political deal that drove monetary union – unreserved French support for German unification in return for Germany giving up the Deutschemark and surrendering de facto German control of European monetary policy, with France having a seat at the table of a new European monetary institution

The quid pro quo was that Germany got to design the institutional and governance structures of the new Monetary Union.

The history and politics of monetary union

The German model: independent anti inflationary central bank; export growth model based on high end luxury goods; social partnership and co-operation.

A whole system of supportive social and institutional relationships made Germany a successful export economy

The supportive social and institutional context that made German macroeconomic frameworks work were not evident elsewhere in Europe

The history and politics of monetary union

ECB price stability mandate – inflation below 2% - a German design – little else – no lender of last resort function, crisis management not specified

The German fear of fiscal free riding, rogue governments buying into its credibility informed the SGP

The fear of rogue profligate governments has persisted to this day and has informed the design of the fiscal compact

The Financial Crash of 2008The sovereign debt crisis is not really a sovereign debt

crisisTotal Irish public debt was 12% of GDP in 2007, but

shot up to 110% of GDP – 3 main Irish banks asset footprint over 400% of GDP – once liabilities were guaranteed private sector debt was transferred onto public balance sheets

The combustion of unsustainable banking models has cost globally $4-11 trillion – only world wars come with a hefitier price tag

The profligate governments discourse is wrong. Europe’s sovereign debt crisis is a transmuted, elongated and camouflaged banking crisis

The Financial Crash of 2008Core European country banks bought lots of peripheral

European debt (sovereign and private) over several years in their search for yield

Leverage of 40:1 in many cases – European banks are Too Big to Bail

French government bonds have come under pressure not because France cannot afford to pay for its welfare state, but because France’s bloated debt ridden banks are too big a liability for the state.

‘Austerity Europe’ – required so that the state and its balance sheet can act as the shock absorber for the entire system

Banks – ‘Bank on the State.’ (Haldane)Greece – the outlier

Re-designing the Euro-Zone’s macroeconomic governance?

Europe’s banking problem caused and is compounding the sovereign debt problem

How to create institutions that minimize future crises and refrain from politically unsustainable forms of austerity when crises do hit is precisely the problem?

The inherent procyclicality of macroeconomic policy is one of the problems that needs to be overcome

A counter cyclical fiscal constitution is needed, - automatic adjusters according to measures of GDP growth

Not a soft solution – rules to require surpluses to be built up during growth years, but providing more flexibility in lean years. The ECJ to have an adjudication role.

A limited fiscal federation and a limited common bond mechanism?

Re-designing the Euro-Zone’s macroeconomic governance?

The ECB tighter control of financial innovation, lean against asset bubbles and require national central banks to operate macroprudential regulation (host country)

Sold to Germany – as limiting the need for future bail outs

Hard but flexible countercyclicality is neededImposed German universalism is not working

and will not work