“The Euro Crisis · the euro area (ank of England) • China –EU is hinas largest export...

“The Euro Crisis:

Challenges and Implications”

Economic Insights:

Conversations with the Dallas Fed

Webcast

Federal Reserve Bank of Dallas

November 7, 2012

hosted by FIRM - Financial Institution Relationship Management

The Euro Crisis:

Challenges and Implications

James F. Hollifield Professor – Southern Methodist University

Director – Tower Center for Political Studies

Mark A. Wynne Senior Economist & Vice President – Federal Reserve Bank of Dallas

Director – Globalization & Monetary Policy Institute

Thomas F. Siems Senior Economist & Director of Economic Outreach



The views expressed are those of the speaker and should not necessarily be attributed

to the Federal Reserve Bank of Dallas or the Federal Reserve System.

“The €uro Crisis”

James F. Hollifield

Professor of International Political Economy

Southern Methodist University

Director of the Tower Center for Political Studies




Three whys and a what

1. Why did ‘Europeans’ come together to create a European Community/Union?

2. Why were they compelled to create a single currency—the €uro?

3. Why is the €uro in crisis today?

4. What can be done to fix it?


The European Union is sui generis

• Unlike anything we have seen before in history

• Not a classic nation-state

• Nor is it just another intergovernmental organization (like the UN)

• It is neither fish nor fowl

• It is a supra-national body in which European states have ‘pooled’ their sovereignty

• Something like a Confederation


1. Why Europe?

• Merely the latest effort to unite Europe?

• A clear strategic rationale—to stop the slaughter!

• To rebuild after 1945 and make Europe a player once again on the world stage

• A Franco-German initiative to build a common market

• Pragmatic but also idealistic


A great liberal project

• You cannot join ‘the club’ unless you are a liberal parliamentary democracy

• A democratic but also a market-oriented club

• Peace and prosperity will come through trade

• Open, market economies

• Fulfillment of the Kantian dream of ‘perpetual peace’

• But start with small, manageable goals


From Rome to Lisbon

From six to twenty seven!


Three pillars

1. EEC (customs union, Rome)→EC (Community and common market, SEA)→EU (Union, Maastricht)→EMU (single currency)

2. CFSP (common foreign, security and defense policy?)

3. JHA (Justice & Home Affairs—border free Europe, common border, immigration, asylum, policing—Schengen)


Broadening v. deepening

• Loose confederation or a federal, United States of Europe?

• De Gaulle and l’Europe des patries

• From six to nine to twelve to fifteen … to twenty seven!

• France was the political leader and Germany was the economic engine

• Where is Perfidious Albion?

• What of the ‘democratic deficit?’


2. Why EMU and the €uro?

• The Werner Report—1970

• 1970s and collapse of the Bretton Woods system of fixed exchange rates

• End of the ‘trentes glorieuses’

• The ‘snake,’ Giscard & Schmidt

• From the ECU to the DM

• From the ‘franc fort’ to the ERM to Maastricht


End of Cold War

A moment of high idealism

• German Unification, 1989

• A German Europe or a European Germany?

• Visions of Weimar and the Bundesbank

• Kohl and Mitterrand (and Thatcher and GHWB!)

• Collapse of the ERM and the annus horribilus!

• Dye had been cast for EMU


3. Why is the €uro in crisis today?

• Europe is not an ‘optimum currency area’

• European Stability and Growth Pact

• Radical convergence of high and low-productivity countries

• Rapid consolidation of capital markets, but without a banking union

• Sovereign spreads—PIIGS thought they had died and gone to heaven! Cheap capital!


Lack of institutions

• ECB—not a national bank, lender of last resort

• No treasury to issue common debt

• No legislature to fix taxation and spending policies

• No agencies for regulating banks (FDIC) or for regulating securities markets (SEC)

• Result was a gigantic spending spree, housing bubble, and financial crisis


4. What can be done to fix it?

• How to get out of a very deep financial hole

• Who will underwrite sovereign debt?

• Will it be ‘mutualized?’

• Who will underwrite the banks?

• How can Europe and the northern countries in particular avoid ‘moral hazard?’

• Sound familiar?


Dejà vu all over again

• The US Articles of Confederation?

• Need for a ‘constitutional convention’

• A National Bank

• Where is Alexander Hamilton when you need him?

• Or Jean Monnet?

• But we do have ‘Super Mario’


“The Euro Crisis and

the Perils of Burning Ships”

Mark A. Wynne

Senior Economist & Vice President


Director of the Globalization & Monetary Policy Institute




Overview

• The story so far…

• The (increasingly global) fallout – Contagion from periphery to core

– Contagion to the rest of the world

• The fundamental challenges – Burned ships (the Cortes strategy)

– The world’s greatest game of chicken

• Lessons from history

• End game – Move to a political union?

– Or lost decade(s) à la Japan?


The euro crisis: a chronology

• May 2010: Greek bailout €110 bn

• November 2010: Irish bailout €85 bn

• April 2011: Portuguese bailout €78 bn

• July 2011: Second Greek bailout €130 bn

• December 2011: Fiscal compact agreed; ECB LTROs

• April 2012: Greek default

• Summer 2012

– Yields on Spanish government debt reach record highs

– €100 bn bailout of Spanish banks

– Yields on stronger sovereigns go negative on safe-haven flows

– ECB cuts deposit rates to zero

• July 26: “…the euro is irreversible…. Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

– ECB President Mario Draghi


Major developments

August – September 2012 • September 6

– ECB announces plans to conduct Outright Monetary Transactions (OMTs) “…to safeguard the monetary policy transmission mechanism in all countries of the euro area” and “…address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro”

– One dissenting vote: Bundesbank President Weidmann

• September 12

– German constitutional court rules that Germany can contribute to the European Stability Mechanism

• September 12

– European Commission publishes proposals for a European banking union

– Focus on bank supervision; issues of deposit insurance and bank resolution unaddressed


Greece: in depression

Gross government debt as a percentage of GDP

100

120

140

160

180

200

2009 2010 2011 2012 2013 2014 2015 2016

Greek budget report Oct. 31, 2012

IMF's World Economic Outlook October 2012

Review of bailout program March 2012 (Estimates overlap with 2012 IMF data for 2009-2011)

Original bailout program May 2010

Estimates Projections

Percent

Ireland: life after austerity?

100

120

140

160

180

1.6

1.8

2.0

2.2

1999 2001 2003 2005 2007 2009 2011 2013

Millions Bil. Ch. 2009 euros

Sep 2012 UR: 15.1% Sep 2012 youth UR: 34.5%

Peak-to-trough decline through 2011: 14.5%


Note: Diamonds indicate OECD forecasts.

July 26, 2012: Ireland returns to financial markets for first time since September 2010

Employment GDP

Portugal: further contraction expected

145

150

155

160

165

4.4

4.6

4.8

5.0

5.2

1999 2001 2003 2005 2007 2009 2011 2013






Employment GDP

Spain: latest bailout request

750

825

900

975

1050

1125

14

15

16

17

18

19

20

21

1999 2001 2003 2005 2007 2009 2011 2013






Employment GDP

OECD NEET Ratios, 15 to 24 Years

0.3

-0.9

2.1 2.7

7.4 5.9 2.5 3.4

-10

-5

0

5

10

15

20

25

30

35

40

Germany Portugal Euro area 17 USA Ireland Spain Greece Italy

Change Q1 2007 to Q1 2011

Q1 2007

Q1 2011

OECD = Organization for Economic Cooperation and Development NEET = not in education, employment, or training Source: OECD Employment Outlook 2012

Percent

Germany PMI in contraction phase

30

35

40

45

50

55

60

65

2005 2006 2007 2008 2009 2010 2011 2012

Expansion

Contraction

Index

Services Composite

Manufacturing

Broader euro-area PMI also in negative territory

30

35

40

45

50

55

60

65

2005 2006 2007 2008 2009 2010 2011 2012

Expansion

Contraction

Index

Services Composite

Manufacturing

Global fallout Exports to the U.S. and euro area: share of world total

6

8

10

12

14

16

18

1980 1985 1990 1995 2000 2005 2010

Percent

U.S.

Euro area

Global fallout

• United Kingdom – 50 percent of exports to euro area – “The greatest threat to the recovery stems from the risk that an

effective policy response is not implemented sufficiently promptly in the euro area” (Bank of England)

• China – EU is China’s largest export market, overtaking U.S. in 2007 – “capricious development of the European debt crisis” as drag on

growth (People’s Bank of China)

• United States – 20 percent of exports to Europe – “… strains in global financial markets continue to pose significant

downside risks to the economic outlook” (FOMC)


German cross-border lending

0

50

100

150

200

250

300

350

400

450

500

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Ireland

Portugal

Greece

Italy

Spain

Net lending (€bn)


The story so far (10-year government interest rates)

0

5

10

15

20

25

30

1990 1995 2000 2005 2010

Percent Greece

Portugal

Spain

Ireland

Italy

Belgium

France

Austria

Netherlands

Finland

Germany

Jan 1, 1999 Euro launched

Jan 1, 2001 Greece joins

One-size-fits-all monetary policy: Euro & U.S.

-15

-10

-5

0

5

10

15

20

1999 2001 2003 2005 2007 2009 2011

Euro area Taylor rate range

U.S. regions Taylor rate range

ECB policy rate

Federal funds rate

Percent

Euro area average range (1999-2011) = 10.6 U.S. regions average range (1987-2011) = 5.2

(Taylor rate change)

Labor mobility a hindrance to a common monetary policy

0

5

10

15

20

25

30

1999 2001 2003 2005 2007 2009 2011

Euro area unemployment range

U.S. BEA regions unemployment range

Percent

Euro area average unemployment range (1999-2012) = 10.0 U.S. BEA regions average unemployment range (1999-2012) = 2.6

(Regional variation in unemployment rates)

Fixes

• Monetary union can exist without a fiscal union

– But need rules to make it work

– Tried and failed in Europe

• Fiscal & political union along U.S. lines

– Tighter constraints on ability of member states to run deficits

– Pooling of regional risks, especially of banking system risks


Lessons from history

• The United States in 1780s – Fiscal crisis associated with servicing debt incurred

during Revolutionary War

• Solution: strengthen powers of federal government (replace Articles of Confederation with U.S. Constitution) – Federal government assumed debts of states

– One-time bailout: states allowed to default in 1840s

– States adopted balanced budget rules thereafter


Deficits in peripheral European countries comparable to U.S. deficits

-14

-12

-10

-8

-6

-4

-2

0

2

4

1999 2001 2003 2005 2007 2009 2011

Peripheral Europe: GDP-weighted fiscal balance

U.S.

Percent Budget deficits as a % of GDP

Fiscal situation of Europe as a whole relatively sound

30

40

50

60

70

80

90

100

1999 2001 2003 2005 2007 2009 2011 2013

Percent


U.S.

Euro area

Government debt as a % of GDP

Disunion

• Declining trust in European institutions

– Just 31 percent compared to 57 percent before crisis

• Less favorable image of the EU

• Majority (52 percent) still support the single currency

– Down from 61 percent before crisis


Conclusions

• Euro crisis is spreading from the periphery to the core, and increasingly weighing on global economic activity

• LTROs of December 2011 and February 2012 have bought time – ECB rate reduction and possible revival of securities market program

can ease strains – ECB is involved in a game of chicken with national governments

• New “fiscal compact” – A significant improvement over earlier Stability and Growth Pact?

• Challenges – Achieving consensus on new rules: loss of sovereignty – Market rigidities – Austerity programs – Potential for social unrest

• Europe 1914


“The Euro Crisis:

Challenges and Implications”

Economic Insights:

Conversations with the Dallas Fed

Webcast


November 7, 2012


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