Panel on the Euro Crisis

Jeffrey FrankelHarpel Professor of Capital Formation and Growth

Center for European Studies,Harvard UniversityFebruary 13, 2014

Three structural drawbacks are built into the monetary union.

• (I) The competitiveness problem – arises from the inability of members to devalue (& loosen money).– Thoroughly anticipated by “Optimum Currency Area” warnings.– Example of the OCA problem: Ireland needed tighter monetary policy

than the ECB’s during 1999-2007, and has needed looser since 2008.

• (II) The fiscal problem, in particular, moral hazard,– arises from keeping fiscal policy primarily at the national level. – It was well-anticipated by architects of Maastricht.

• Pushed by German taxpayers afraid they’d have to bail out Club Med,• they produced Maastricht criteria, No Bailout Clause, SGP, & successors.• All failed, from day 1.

– Greece is the worst example.

• (III) The banking problem, – arises from keeping bank supervision at the national level.– It received very little discussion at Maastricht.

Overviews: Shambaugh (2012) “The Euro’s Three Crises” & Lane (2012) "The European Sovereign Debt Crisis" 2

(I) THE COMPETITIVENESS PROBLEM

During the euro’s first decade, wages & ULCs rose faster in the periphery than in Germany.

Source, IMF/ECB via M.Wolf, FT 10/10/12

Figure 3: Figure 4:

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Since 2008, some of the wage gap has been reversed.

Huge current account deficits in periphery countries up to 2007 were seen as benign reflections of optimizing

capital flows, instead of warning signals.Figure 5:

Source: World Bank, PREM, 2012. Data from IMF WEO Database Source: Krugman. “Which Way to the Exit?” Brussels, 2012

Figure 6:

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(II) THE FISCAL MORAL HAZARD PROBLEM

Given the high debts, the ECB must have been seen as standing behind them.

Figure 1

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Periphery-countries’ interest rates converged to Germany’s after they joined the euro

=> investors perceived no default risk.

The Greek budget deficit in truth had never come below the 3% of GDP ceiling. Nor did the debt/GDP ratio (≈100%) ever decline in the direction of the 60% limit.

Figure 2

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Debt/GDP ratios have been rising sharply, as high interest rates & declining GDP overpower progress on

reduction of primary budget deficits.

Via: World Bank, PREM, 2012 7

As one could have predicted, fiscal contraction is contractionary

Source: P.Krugman, 10 May 2012, via R.Portes, May 2013.

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The financial situation has improved since Nov. 2011, when Mario Draghi became ECB President.

LTROs (somewhat like TARP)

-- Dec.2011 & Feb.2012

“Within our mandate,

the ECB is ready to do whatever it takes to preserve the euro.

And believe me, it will be enough.” (like lender of last resort) -- July 2012

(but with conditionality) OMTs -- Aug.2012

The decline in periphery interest rateshas come despite continued rise in Debt/GDP ratios.

10de Long

Possible paths forward in the 3 areas of crisis

• (I) The competitiveness problem: – The periphery is “toughing out” internal devaluations.

• (II) The fiscal problem:– hardest of all.– Germany is right about moral hazard (in LR),

but wrong about “expansionary fiscal contraction” (in SR).

• (III) The banking problem: – Encouraging moves toward a banking union.

• But it would require commonizing all three: ex ante supervision, deposit insurance & resolution of failed banks.

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(I) Painful adjustment has taken place

12Breugel

Unit Labor Costshave come down slowly…

…at the cost of still-high unemployment.

Adjustment in the periphery is that much harder when eurozone-wide inflation < 1%.

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The EU leaders should have reacted to the Greek debt crisis as Washington reacted to the southern states’ crisis in 1841.

• When the crisis erupted in Athens in late 2009, Frankfurt & Brussels should have seen it as a golden opportunity.

• They already knew their attempted fiscal constraints had failed. – So even the leaders must have known that sometime

during the euro’s life it would be challenged by debt troubles among one or more members.

– It was important to get the first case right, to set the correct precedent.

14Frankel, “The Greek debt crisis: The ECB’s three big mistakes,” VoxEU, May 16, 2011.

(II) The fiscal/moral hazard problem is worse, not better.

The EU should have reacted to the Greek crisis as Washington reacted in 1841.

• Greece was the ideal test case, for two reasons: – 1) Unlike Ireland or Spain, it was egregiously at fault,

• a natural place to draw a line, its creditors the natural ones to suffer losses.

– 2) Unlike Italy, it was small enough that other governments and systemically important banks could have been protected from the consequences of a default,

• at a fraction of the cost of the EFSF, ESM, etc.

• In early 2010 the EC & ECB should have urged Greece to go to the IMF and, if necessary, to restructure its debts, – rather than calling this course “unthinkable.” – The odds of containing the fire would have been far better than later.

15Frankel, “The Greek debt crisis: The ECB’s three big mistakes,” VoxEU, May 16, 2011.

Writings by Jeffrey Frankel:

• "The Future of the Currency Union," written for Academic Consultants Meeting, Federal Reserve Board, May 2013; slides. HKS RWP13-015.

•  "Over-optimistic Official Forecasts and Fiscal Rules in the Eurozone," with Jesse Schreger, 2013, in Review of World Economy (Weltwirtschaftliches Archiv) 149, no.2, 2013. NBER WP 18283, 2012.   Described in "Will Europe's Fiscal Compact Work?" Project Syndicate, Jan.2013.

•"Over-optimism in Forecasts by Official Budget Agencies and Its Implications," Oxford Review of Economic Policy Vol.27, Issue 4, 2011, 536-562. NBER WP 17239; Summary in NBER Digest, Nov.2011.

• “Which Eurobonds?" Project Syndicate, June 2012. Full version: "Could Eurobonds Help Solve the Euro Crisis?" Vox, June 2012.• "The Euro Crisis & Greece: Six Mistakes,” Kokkalis Program, Feb.13, 2012.•“The ECB’s Three Big Mistakes,” VoxEU, May 16, 2011.•"Let Greece Go to the IMF," Jeff Frankel’s blog, Feb.11, 2010.•“‘Excessive Deficits’: Sense and Nonsense in the Treaty of Maastricht; Comments on Buiter, Corsetti and Roubini,” Economic Policy, Vol.16, 1993.

Appendix 1:

Two ideas to help restore LR credibility to fiscal rules

(after eliminating legacy debt overhang)

• Problem: No version of the SGP or Fiscal Compact has come up with a way to prevent national authorities from making overly optimistic budget forecasts ex ante and then, when exceeding the caps ex post, saying it was beyond their control. Who gets put in jail?

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Addressing the ex ante problem

• Officials in most advanced countries make overly optimistic forecasts of growth and budgets. 1/

• Particularly in euroland: – When the budget exceeded 3% of GDP,

the authorities adjusted their forecasts, not their policies. 2/

• Solution: delegate the authority to forecast GDP and budgets to independent expert councils or agencies. 3/

1/ Frankel, 2011, “Over-optimism in Forecasts by Official Budget Agencies and Its Implications," Oxford Review of Economic Policy, 27, no.4. NBER WP 17239.

2/ Frankel & Schreger; 2013, "Over-optimistic Official Forecasts in the Eurozone and Fiscal Rules," Review of World Economy, no.2 (Kiel). NBER WP 18283.

3/ Frankel, 2012, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” Central Bank of Chile and NBER WP 16945.

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Optimism bias in official forecasts, continued

• Fiscal rules are the current fashion. Do they help?• Example of failure of fiscal rules

– in the presence of official forecast bias

• The Greek government projected in 2000 that its budget deficit would shrink– below 2% of GDP one year in the future and

– below 1% of GDP two years into the future, and – that it would swing to surplus 3 years into the future.

• The actual deficit: 4-5% of GDP, well above the 3%-of-GDP ceiling.

Even though true Greek budget deficits in most years were far in excess of the supposed limit (3% of GDP),

20Source: Frankel & Schreger (2011)

the the official budget forecasts were always rosy.official budget forecasts were always rosy.

Until, in 2009, the bottom fell out of the budget.

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In the euro countries, which are subject to SGP rules, the optimism bias is captured by the practice of never

forecasting next year’s budget deficit > 3% of GDP.

In the euro countries, which were subject to SGP rules, the optimism bias is reflected in the practice of never

forecasting next year’s budget deficit > 3% of GDP.

Frankel & Schreger (2013)

Private-sector forecasts surveyed by Consensus Forecasts are free to forecast budget deficits > 3% of GDP.

Addressing the ex post problem

• Eurobonds might play a useful role: The world’s reserve holders crave an alternative to US T bills.– But most existing Eurobond proposals imply a “transfer union,”

which Northern European taxpayers cannot be asked to support.

• The Eurobond version that might work goes under the name of “blue bonds,” proposed by two economists at the think tank Bruegel.1/

• Only debt issued by national authorities below the 60% criteria would receive eurozone backing & effectively become Eurobonds. – These are the “blue bonds” that investors would view as safe. – If a country issued debt > 60% threshold, the resulting “red bonds”

would lose eurozone backing; the issuer would be fully liable.  

1/ Jacques Delpla & Jakob von Weizäcker “The Blue Bond Proposal,” Breugel, May 2010.22

Addressing the ex post problem, continued

• As I see it, private markets would judge whether a country was crossing the 60% threshold, even before the final statistics were available, 2/ – and therefore whether a new default risk required an interest rate premium.

• The sovereign risk premium would operate -- – much as it does among American states, – and as it did in Italy, Greece and the others before they joined the euro.

• The point is that the mechanism would be truly automatic. – Perhaps in borderline cases the judgment whether a country had truly

exceeded the limit would ultimately have to be made by a court. – But private investors would act from moment to moment.– Market interest rates would provide the missing automatic discipline.

• Thus compliance would not rely on Brussels bureaucrats, – whose discretionary letters have proven toothless

• no matter how many exclamation points are put at the end.

2/ Frankel , 2012, “Could Eurobonds Be the Answer to the Euro Crisis?” VoxEU, June 2012. 23

Even though many Emerging Market countries learned from the sovereign debt crises

of the 1980s & 1990s, e.g., learned to run countercyclical fiscal policy,

leaders in euroland failed to do so.

• They thought a sovereign debt crisis could never happen to them.

– even after the periphery countriesviolated the deficit & debt ceilings of Maastricht and the SGP.

Appendix 2

But Reinhart & Rogoff remind us: sovereign default is an old story, including among advanced countries –This Time is Different, updated in “From Financial Crash to Debt Crisis,” 2010

Sovereign External Debt: 1800-2009. Percent of Countries in Default or Restructuring

50%-

Sources:Lindert & Morton (1989), Macdonald (2003), Purcell & Kaufman (1993), Reinhart, Rogoff & Savastano (2003), Suter (1992), and Standard & Poor’s (various years). Notes: Sample size includes all countries, out of a total of sixty six listed in Table 1, that were independent states in the given year

1980s1930s1870s1830s

Appendix 3 – Questions from the Fed Governors:“In the current environment, how should monetary policy

operate given…such diverse shocks?”

• The ECB should follow an easier monetary policy – than it generally has in the last 4 years.

• => higher inflation rates & depreciation.

• Will help Club Med improve its relative price competitiveness.• German horror is understandable;

– they are entitled to their “morality tale.”

• But if the euro is to survive, the Germans must give way on some things that they very deliberately did not sign up for at the start. – They especially must give way on the absurd premise that

austerity is expansionary, as if we learned nothing from the 1930s.

• The ECB has already moved in the right direction under Draghi, – LTROs & OMTs.

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Question: “Can the monetary union be achieved in the long run without a significant increase in fiscal unity?”

Full fiscal union? No. The German taxpayers who were afraid that the euro would

lead to a fiscal bailout were proven right (and the elites proven wrong). Why should they believe

that there will be no future bailouts? 27

No. “More Europe” is now inescapable.

In the medium run, debt/GDP ratios must be put back on a sustainable path

through write-downs of “legacy debt,” “re-profiling,”financial repression, bank bailouts, EFSF, ESM, ECB, etc.

Question: “Is fiscal unity politically possible?”

Question: “Are comparisons with the United States useful?”

• (I) Regarding loss of monetary independence: – Prospective € members did not satisfy OCA criteria

among themselves as well as the 50 American states do: • trade, symmetry of shocks, labor mobility, market flexibility,

& countercyclical cross-state fiscal transfers.• Endogenous change in these parameters has been insufficient.

• (II) Regarding moral hazard from states’ fiscal policy:– The US federal government has bailed out no state since 1790

– and nobody expects it to do so now.

– How did the US vanquish state-level moral hazard? 28

Yes. The US is a successful monetary union.

The secret US ingredient is especially relevant for Merkel’s reforms to give enforceability & credibility

to the eurozone targets for deficits & debt, after the repeated earlier failures of the SGP.

• The Fiscal Compact technically sets deficit targets stricter than SGP,

• though at least they are specified in cyclically adjusted terms.

• Countries must put the euro-wide targets into their national laws.

• As rationale, some point to fiscal rules among the 50 states.– Do they explain the absence of moral hazard in the US?

– Or is it the way spreads on the debts of spendthrift states rise, • long before debt/income ratios reach anything like European levels?

– The fundamental explanation: The decision to let 8 states default in 1841-42 rather than bail them out was a critical precedent.

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Interest rates on periphery bonds have come back down a lot

since Mario Draghi took office at the ECB

Source: Jeffrey Anderson and Jessica Stallings, Feb. 13, 2014 “Euro Area Periphery: Crisis Eased But Not Over,” Institute of International Finance,

Periphery economies remain weak

Source: Jeffrey Anderson and Jessica Stallings, Feb. 13, 2014, “Euro Area Periphery: Crisis Eased But Not Over,” Institute of International Finance, Chart 3

Unemployment in periphery countries remains very high

Source: Jeffrey Anderson and Jessica Stallings, Feb. 13, 2014 , “Euro Area Periphery: Crisis Eased But Not Over,” Institute of International Finance, Chart 1

The periphery countries had by 2013 managed to reverse most of the run-up in costs

(but not Italy)

Source: Jeffrey Anderson & Jessica Stallings, “Euro Area Periphery: Crisis Eased But Not Over,” Institute of International Finance, Feb. 13, 2014, Chart 5.