Institutions of Macroeconomic PolicyInstitutions of Macroeconomic Policy

Jeffrey FrankelJeffrey FrankelHarpel ProfessorHarpel Professor

Advanced Workshop on Global Political Economy,Advanced Workshop on Global Political Economy,Institute for Global Law & Policy, Harvard Law SchoolInstitute for Global Law & Policy, Harvard Law School

Lecture III, June 1, 2012Lecture III, June 1, 2012The Euro CrisisThe Euro Crisis

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Was European Monetary Union Was European Monetary Union a bad idea from the start?a bad idea from the start?

Seven mistakes by euro leadersSeven mistakes by euro leaders

Appendices: Looking forwardAppendices: Looking forward

Was European Monetary UnionWas European Monetary Uniona bad idea from the start?a bad idea from the start?

Pros:Pros:Monetary: A firm Monetary: A firm nominal anchor to end nominal anchor to end inflation among inflation among Mediterranean Mediterranean countries.countries.

Trade: To promote EU Trade: To promote EU economic integration.economic integration.

Political: Political: To improve cohesion.To improve cohesion.

ConsCons::Monetary: Loss of ability Monetary: Loss of ability by each to respond by each to respond to local conditions to local conditions by adjusting money by adjusting money supply, interest rate, supply, interest rate, or exchange rate.or exchange rate.

Political Political (according to M.Feldstein): (according to M.Feldstein):

Could lead to conflict.Could lead to conflict.33

The major grounds for ex ante skepticism The major grounds for ex ante skepticism among (American) economistsamong (American) economists

The euro countries did not meet the criteria The euro countries did not meet the criteria of an Optimum Currency Areaof an Optimum Currency Area

– OCA: Bob Mundell, OCA: Bob Mundell, 19611961 (another Nobel Prize).(another Nobel Prize).

Individual members would be hit Individual members would be hit by individual by individual (“asymmetric”) (“asymmetric”) shocks.shocks.– Lacking Lacking the the high laborhigh labor mobility mobility of the of the US,US,

– where workers adjust to unemployment by moving across states,where workers adjust to unemployment by moving across states,

– euro members would find it very difficult euro members would find it very difficult to abide by a common monetary policy.to abide by a common monetary policy.

– E.g., when a periphery country suffered a loss in demand, E.g., when a periphery country suffered a loss in demand, the interest rates set in Frankfurt would be too high for it.the interest rates set in Frankfurt would be too high for it.

44Comments on “The euro: It can’t happen, It’s a bad idea, It won’t last. U.S. economists on the EMU, 1989-2002,” by Jonung & Drea. Euro at 10, 2009 ASSA mtgs.

In retrospect, economists were correct In retrospect, economists were correct to worry about “asymmetric shocks”to worry about “asymmetric shocks”

But But (1) the shocks were excessive credit-fueled (1) the shocks were excessive credit-fueled boomsbooms in the periphery countries in the periphery countries (2003-07), (2003-07), rather than recessions,rather than recessions,– with Ireland & Spain unable to raise interest rates or appreciate; andwith Ireland & Spain unable to raise interest rates or appreciate; and

(2) the booms showed up in asset prices (housing)(2) the booms showed up in asset prices (housing)– more than in goods market inflation.more than in goods market inflation.

(3) Only after the Global(3) Only after the Global FinancialFinancial Crisis began Crisis began in 2008in 2008

– was the need felt to fight recession with depreciationwas the need felt to fight recession with depreciationE.g. Poland had the best performance, the Baltics had the worst.E.g. Poland had the best performance, the Baltics had the worst.

And only after the Greek crisis began And only after the Greek crisis began in Oct. 2009in Oct. 2009

did the need to devalue become so acute did the need to devalue become so acute as to prompt thoughts of leaving the euro.as to prompt thoughts of leaving the euro.

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But the Maastricht Treaty But the Maastricht Treaty (Dec. 1991)(Dec. 1991)

focused on focused on fiscalfiscal criteria criteria as qualifications for euro membership:as qualifications for euro membership:

BD < 3% of GDP & Debt < 60% of GDP.BD < 3% of GDP & Debt < 60% of GDP.

One might have thought that, giving up the One might have thought that, giving up the instrument of monetary policy, it would instrument of monetary policy, it would become more important for countries to retain become more important for countries to retain the instrument of fiscal policy.the instrument of fiscal policy.

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Why did the designers of MaastrichtWhy did the designers of Maastrichtemphasize fiscal criteriaemphasize fiscal criteria??

TheoryTheory I: I: Jason Jason & the Golden Fleece& the Golden Fleece

TheoryTheory II: II:

Theseus Theseus & the stone& the stone

TheoryTheory III: III: Odysseus Odysseus & the sirens. & the sirens.

Frankel, Economic Policy (London) 16, April 1993, 92-97.

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The motivation forThe motivation for thethe MaastrichtMaastricht fiscalfiscal criteriacriteria

was the same as for the No Bailout Clausewas the same as for the No Bailout Clauseand the Stability & Growth Pact and the Stability & Growth Pact (1997):(1997):

Skeptical German taxpayers believed that, before Skeptical German taxpayers believed that, before the € was done, they would be asked the € was done, they would be asked to bail out profligate Mediterranean countries.to bail out profligate Mediterranean countries.

European elites adopted the fiscal rules European elites adopted the fiscal rules to render these fears were groundless.to render these fears were groundless.

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7 mistakes made by euro leaders7 mistakes made by euro leaders

Admitting Greece to the € in the first place, Admitting Greece to the € in the first place, – a country that was not yet ready by the relevant criteria.a country that was not yet ready by the relevant criteria.

Pretending to enforce the fiscal criteria.Pretending to enforce the fiscal criteria.

Allowing Mediterranean countries’ bond spreads near 0Allowing Mediterranean countries’ bond spreads near 0– helped by investors’ under-perception of risk (2003-07)helped by investors’ under-perception of risk (2003-07)– and artificial high credit ratings. But alsoand artificial high credit ratings. But also– ECB acceptance of Greek bonds as collateral. ECB acceptance of Greek bonds as collateral.

Burying their heads in the sand when the crisis hit in late 2009:Burying their heads in the sand when the crisis hit in late 2009:In early 2010, sending Greece to the IMF was “unthinkable.”In early 2010, sending Greece to the IMF was “unthinkable.”In early 2011, restructuring of the debt was “unthinkable.”In early 2011, restructuring of the debt was “unthinkable.”

The current strategy: The current strategy: austerity for now, austerity for now, unenforceable “Fiscal Compact” for the futureunenforceable “Fiscal Compact” for the future..

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After the euro came into existenceAfter the euro came into existence

it became clear the German taxpayers had been rightit became clear the German taxpayers had been right– and the European elites had beene wrong.and the European elites had beene wrong.

E.g., Greece persistently violated the 3% deficit rule.E.g., Greece persistently violated the 3% deficit rule.

All members violated the rules All members violated the rules at some time, at some time, largelarge && small.small.

SGP targets were “met” by overly optimistic forecasts.SGP targets were “met” by overly optimistic forecasts.

SGP threats of penalty had zero credibility.SGP threats of penalty had zero credibility.

Yet each year the ostrich elites stuck Yet each year the ostrich elites stuck their heads deeper & deeper into the sands.their heads deeper & deeper into the sands.

The Greek budget deficitThe Greek budget deficitnevernever got below the 3% of GDP limit, got below the 3% of GDP limit,

nor did the debt ever decline toward the 60% limitnor did the debt ever decline toward the 60% limit

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Even Greece’s Even Greece’s primaryprimary budget deficit budget deficithas been far in excess of 3% since 2008has been far in excess of 3% since 2008

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Source: IMF, 2011.I. Diwan, PED401, Oct. 2011

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Spreads for Italy, Greece, & other Mediterranean Spreads for Italy, Greece, & other Mediterranean members of members of €€ were near zero, from 2001 until 2008. were near zero, from 2001 until 2008.

Market Nighshift Nov. 16, 2011

When PASOK leader George When PASOK leader George Papandreou became PM in Oct. 2009,Papandreou became PM in Oct. 2009,

he announced he announced – that “foul play” had misstated the fiscal that “foul play” had misstated the fiscal

statistics under the previous government:statistics under the previous government:

– the 2009 budget deficit the 2009 budget deficit ≠≠ 3.7%, 3.7%, as previously claimed, as previously claimed, but > 12.7 % !but > 12.7 % !

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Missed opportunityMissed opportunity

The EMU elites had to know that someday The EMU elites had to know that someday a member country would face a debt crisis.a member country would face a debt crisis.

In early 2010 they should have viewed Greece as a In early 2010 they should have viewed Greece as a good opportunity good opportunity to set a precedent for moral hazard:to set a precedent for moral hazard:– The fault egregiously lay with Greece itself,The fault egregiously lay with Greece itself,

unlike Ireland or Spain, which had done much right.unlike Ireland or Spain, which had done much right.

– It is small enough that the damage from debt restructuring It is small enough that the damage from debt restructuring could have been contained at that time.could have been contained at that time.

They should have applied the familiar IMF formula: They should have applied the familiar IMF formula: serious bailout, but only conditional on serious serious bailout, but only conditional on serious policypolicy reforms reforms && serious Private serious Private SectorSector Involvement.Involvement.

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But the ostriches But the ostriches stuck their heads stuck their heads ever further ever further down in the sand.down in the sand.

Eventually Eventually – Greece, Ireland and Portugal went to the IMF; and Greece, Ireland and Portugal went to the IMF; and – Greek debt was restructured.Greek debt was restructured.

But by then But by then interest rates and debt/GDP ratios were far higher, interest rates and debt/GDP ratios were far higher,

it was too late to draw a line credibly distinguishing it was too late to draw a line credibly distinguishing Greece from the others, even Spain and Italy.Greece from the others, even Spain and Italy.

Any solution to the euro crisis must include:

(i) a way of putting the member countries back on sustainable paths (≡ debt/GDP declining).

(ii) a way of preventing repeats in the future.– As the Maastricht architects knew all along,

this means a way of preventing fiscal moral hazard: preventing individual countries from running big deficits & debts, expecting to be bailed out in the event of a crisis.

(i) Putting countries back on sustainable paths?

The 6th mistake: the German belief that fiscal contraction is expansionary.– It is the same mistake made now by the UK & some in the US,– and is the same mistake made in 1937.

As a result, Debt/GDP ratios in euro countries are rising, – not falling;

= the definition of unsustainable financially,

even if you thought the economic hardship was sustainable politically.

(ii) Preventing moral hazard in the future?(ii) Preventing moral hazard in the future?

The 7th mistake is Merkel’s “fiscal compact”:– yet another unenforceable declaration

of determination to strengthen the SGP,– via budget limits in national laws/constitutions.

– Why should these rules be any more credible than those that came before?

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2020

EMU Ostrich

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References by the speakerReferences by the speaker

““The Hour of the Technocrats,” ,” Project SyndicateProject Syndicate, Nov.15, 2011, Nov.15, 2011..““The ECB’s Three Big Mistakes,” ,” VoxEU, May 16, 2011., May 16, 2011.  “Optimal Currency Areas & Governance", slides session on the session on the Challenge of Europe at the  at the Annual Conference of George Soros’ of George Soros’ INET, April 2011; , April 2011; video available, including my available, including my presentation. .

""Let Greece Go to the IMF," Jeff Frankel’s blog, Feb.11, 2010.," Jeff Frankel’s blog, Feb.11, 2010.Over-optimism in Forecasts by Official Budget Agencies and Its Implications," ," Oxford Oxford Review of Economic Policy, Review of Economic Policy, 2011.2011.““A Solution to Fiscal Procyclicality:  The Structural Budget Institutions Pioneered by Chile,” ,” Fiscal Policy and Macroeconomic Performance, Fiscal Policy and Macroeconomic Performance,  Central Bank of Chile, 2011.  NBER  Central Bank of Chile, 2011.  NBER WP 16945, WP 16945, April 2011. 2011. “The Estimated Effects of the Euro on Trade:  Why are They Below Historical Evidence on Effects of Monetary Unions Among Smaller Countries?” in ” in Europe and the Euro, , Alberto Alesina Alberto Alesina & & Francesco Giavazzi, eds. Francesco Giavazzi, eds. ((U.Chic.Press), ), 2010.    2010.   

"Comments on 'The euro: It can’t happen, It’s a bad idea, It won’t last. U.S. economists "Comments on 'The euro: It can’t happen, It’s a bad idea, It won’t last. U.S. economists on the EMU, 1989-2002,' by L.Jonung & E.Drea," on the EMU, 1989-2002,' by L.Jonung & E.Drea," slides. . Euro at 10: Euro at 10: Reflections on American Views, ASSA meetings, San Francisco, 2009. , ASSA meetings, San Francisco, 2009. "The UK Decision re EMU: Implications of Currency Blocs for Trade and Business Cycle Correlations," in in Submissions on EMU from Leading Academics (H.M. Treasury: London), 2003.(H.M. Treasury: London), 2003."The Endogeneity of the Optimum Currency Area Criterion," with Andrew Rose,      The Economic Journal, 108, no.449, July 1998., 108, no.449, July 1998.“‘Excessive Deficits’: Sense and Nonsense in the Treaty of Maastricht; Comments on Buiter, Corsetti and Roubini,” Economic Policy, Vol.16, 1993.    

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Appendices:

• (A) In the US system, how do the fiscal policies of the 50 states avoid moral hazard?

• (B) The ECB’s LTROs (Dec. 2011-Feb 2012)

• (C) Any solution for the long term?

• (D) Restoring competitiveness via the exchange rate: Poland vs. the Baltics

Appendix A: Perhaps the Fiscal Compact misunderstands the US system

Yes, despite a common currency, the 50 states do not seem to have moral hazard:– The federal government has never bailed one out,

and nobody expects it to now.

– But that is not due to the budget rules that (49 of) the states have.

Their rules are voluntary, varied, and flexible.

Some states do have debt troubles, – and even default.

How the US avoids moral hazard in the 50 states

Government spending at the state level is a far smaller share of income than at the federal level, – let alone on the part of European states.– Is Europe ready for that? No.

When one state begins to run its debt too high, the private market automatically imposes an interest rate penalty.– E.g., California today.– Gives states the incentives to get back in line.– This mechanism was expected to operate in euroland

Alesina, et al Alesina, et al ((EPEP, 1992) and , 1992) and Goldstein & Woglom Goldstein & Woglom (1992).(1992).

but conspicuously failed from the first day.

– Which showed that moral hazard had not been addressed.

Nobody expects the U.S. Federal government Nobody expects the U.S. Federal government to bail out indebted states: The precedent was set to bail out indebted states: The precedent was set

170 years ago, when 8 states were allowed to default.170 years ago, when 8 states were allowed to default.

2525When States Default: 2011, Meet 1841, WSJ

In the early 1940s,5 states repudiated their debts completely(Michigan, Mississippi, Arkansas,

Louisiana & Florida) while a few more were in default for several years.

Spreads help keep profligate US states in line.

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California Municipal BondsCalifornia Municipal Bonds(now the lowest rated of the 50 states)(now the lowest rated of the 50 states)

Credit Default SwapsCredit Default Swapshttp://blogs.reuters.com/muniland/2011/06/08/muni-sweeps-lockyer-rides-again/http://blogs.reuters.com/muniland/2011/06/08/muni-sweeps-lockyer-rides-again/

Appendix B: Mario Draghi became President of the ECB, Nov.1, 2011

He was under intense pressure to expand his predecessor’s purchases of large quantities of periphery-country bonds.– The ECB was urged to be the “big bazooka”:

to buy troubled governments bonds.

– If the ECB interpreted its mandate literally, as no more than keeping inflation low, then the euro might break up.

On the other hand, as Draghi knew:– the ECB is legally prohibited from financing governments directly;– If he had bailed out Italy & the others, he would have:

facilitated a continuation of Berlusconi-style irresponsibility;been immediately written off by Germans as another profligate Italian.

Draghi’s LTRO (Longer-Term Refinancing Operation) was a great success.

On Dec. 22, he caught everyone by surprise by the clever ploy of doing exactly what he had previously announced he would do:– loans to banks for 3 years, at low interest.

High take-up– Brought down interbank & country spreads,

while consistent with central bank LoLR mandate.

2nd round in late February was equally successful.

But the LTRO rounds were not a solution;– They only bought a little time.

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Appendix C: Appendix C: Proposal for the long term #1Proposal for the long term #1

Emulate Chile’sEmulate Chile’ssuccessful fiscal institutions:successful fiscal institutions:

Give responsibility for determining Give responsibility for determining what is a structural deficit and what what is a structural deficit and what is a cyclical deficit to an independent is a cyclical deficit to an independent professional agency, to avoid forecast bias.professional agency, to avoid forecast bias.

(Frankel, 2012)(Frankel, 2012)

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Proposal for the long term #2Proposal for the long term #2

PenaltyPenalty when a euro country misses its target:when a euro country misses its target:

a)a) The ECB then stops accepting new bonds as collateral.The ECB then stops accepting new bonds as collateral.

b)b) => Sovereign spread rises, with automaticity.=> Sovereign spread rises, with automaticity.

c)c) Proposal from BrueghelProposal from Brueghel ((JvW & & ZD): D): All of euroland is liable for All of euroland is liable for blue bondsblue bonds

(issued up to SGP limits); (issued up to SGP limits); Issuing country is liable for Issuing country is liable for red bondsred bonds

(beyond those limits) .(beyond those limits) .

d)d) Blue bonds share advantages with other eurobond Blue bonds share advantages with other eurobond proposals:proposals:

a)a) ● ● ECB can conduct monetary policy.ECB can conduct monetary policy.b)b) ● ● They could offer an alternative to US TBills They could offer an alternative to US TBills

for PBoC & other desperate global investorsfor PBoC & other desperate global investors

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Blue bonds & red bondsBlue bonds & red bonds

Gavyn Davies, FTSource:

Appendix D: Restoring competitiveness Appendix D: Restoring competitiveness via devaluation: Poland vs. the Balticsvia devaluation: Poland vs. the Baltics

Poland,Poland, the the only continental EU member with a floating only continental EU member with a floating exchange rate, was also the only one to escape exchange rate, was also the only one to escape negative growth in the global recession of 2009negative growth in the global recession of 2009

2006 2007 2008 2009 2010 Exchange Rate

Poland6.2  6.8  5.1  1.7  3.5f 

Floating

Lithuania7.8  9.8  2.9  -14.7  -0.6f 

Fixed

Latvia12.2  10.0  -4.2  -18.0  -3.5f 

Fixed

Estonia10.6  6.9  -5.1  -13.9  0.9f 

Fixed

Slovakia8.5  10.6  6.2  -4.7  2.7f 

Euro

Czech Republic6.8  6.1  2.5  -4.1  1.6f 

Flexible

Hungary3.6  0.8  0.8  -6.7  0.0f 

Flexible

Source: Cezary Wójcik, 2010

(de facto)% change in GDP

The depreciation boosted net exports; The depreciation boosted net exports; contribution to GDP growth contribution to GDP growth >> 100% 100%

3,2

3,5

3,7

4,0

4,2

4,5

4,7

I III V VII IX XI I III V VII IX XI I III V VII IX

2008 2009 2010

8,0

13,0

18,0

23,0

28,0

Contribution of Net X to GDP:

2009: 2,5 3,4 3,2 3,4

> 100% ofPoland’s GDP growth rate: 1,7

Source: Cezary Wójcik

kroon / $

Estonia

Latvialats / $

zlotys / $

The Polish exchange rate increased by 35%.

Jeffrey FrankelJeffrey Frankel

Advanced Workshop on Global Political Economy,Advanced Workshop on Global Political Economy,

End of Lecture IIIEnd of Lecture IIIThe Euro CrisisThe Euro Crisis