Recent Developments in Europe and International Financial

Markets: Much Ado about EMUAndrew K. RoseBerkeley, Haas

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One Big Potential Threat

• International Financial Markets are worried about EMU– Distress throughout 2010 and 2011– Relative Calm early in 2012• Draghi’s trillion euro loans to banks

– Fears now Returning• “Austerity Fatigue”• Many Elections

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Beware Greeks Bearing Bonds• Sovereign default was inevitable– So far voluntary; “disorderly” to come?– Ireland? Portugal? Spain?

• Current Greek 10-yr bond >30% – German ≈2% (US, UK, Japan too)

• Government Debt unsustainable (≈150% GDP)– German ≈ 80%

• Big government deficits (≈10% GDP) imply continuing deterioration– German ≈ 1%

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How Could This Happen?

• Article 103 (“No Bail-Out”) Maastricht Treaty– “… neither the Community nor any Member State

is liable for or can assume the commitments of any other Member State”

• But when push came to shove, spirit of Treaty violated

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Evolving E-Bailout Institutions• European Financial Stabilization Mechanism (EFSM)

– EC funds (from EU budget) of €60 bn• European Financial Stability Facility (EFSF)

– May 2010: to “safeguard financial stability in Europe”– Can issue €440 bn of bonds, guaranteed by members, to lend to members “in

difficulty” who request help, s.t. EC, ECB, IMF (“troika”) conditionality– Greece requested and received rescue package from EU/IMF (€110 bn), May

2010– Ireland and Portugal followed

• European Stability Mechanism (ESM)– Permanent bailout kitty aka “Firewall”– Increased in late March 2012 to €500m, starts 7/2012, fully ready by 2014 (!)

– Probably still too small (German objections; France + others wanted €1 tn– EFSF + ESM limit is €700 bn

• European Monetary Fund (EMF) starts July 2012

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How Did We Get Here?

• Important to Understand Membership

Requirements for EMU

• Five “Convergence Criteria” required for entry

• To be applied by the “Council of Ministers”

• Mostly Economic, but Highly Politicized

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Convergence Criteria, 1

Institutions– Central bank independence– Easy!

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Convergence Criteria, 2

Inflation– CPI inflation within 1.5% of target– Target is average inflation of three countries with

lowest inflation– Still easy!

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Convergence Criteria, 3

Interest Rates– Average long-term interest rates within 2% of

target;– Target is average long-term interest rate of the

three low-inflation countries– Note: some “wiggle-room” for sovereign risk premia

– Again, easy!

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Convergence Criteria, 4

Exchange Rates– Fixed Exchange Rates within “normal bounds”

(15%!)– No realignment within last two years– Once more: easy!

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Convergence Criteria, 5

Fiscal Positions•Members must have “Sustainable Government Financial Position” defined as:

a) Flow: Deficit/GDP ratio of less than 3%, andb) Stock: Debt/GDP ratio of less than 60%– “Escape clauses” exist for “temporary

circumstances” or declining debt•Not so easy!– Most scraped in– Greece lied its way in

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Stability (and Growth) Pact

• EMU “Ins” should maintain deficits of less than 3% GDP while in EMU or face penalties – German origins– Implies pro-cyclic fiscal policy (!)

• Widely flouted by large countries in practice– France ‘03-’07, Germany ‘03-’06, Italy ‘03-?– Also breaches by Greece, Netherlands, Portugal– Reformed slightly in 2005– Revived at summit in December 2011

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Hence More Fiscal Austerity

• Considerable pressure on Greece to raise taxes, cut spending (and exacerbate 4-yr recession)– Portugal, Spain, Ireland too– German View: Roasting the Meat (or Burning it?)

• But … will this work?– The markets don’t think so– Most commentators agree with markets

• Right way to approach the problem?

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How Should One Think about EMU?

• Economists (and Haas MBA students) usually

ask two questions on EMU

1. “Do European Countries look like an ‘Optimum

Currency Area’?”

2. “Are European Countries similar to American

Regions?”

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“Optimum Currency Areas”

• Mundell’s Nobel Idea: When are two regions

more likely to gain from common currency?

1. If they share deep trade links and

– Single currency reduces transaction costs of trade

2. If they have similar business cycles

– Same monetary policy appropriate

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But if Two Regions have Asymmetric Business Cycles …

• Need to be able to Adjust to “Asymmetric

Shocks” (good for one region, bad for another)

• Otherwise boom in one region causes inflation

• Recession in other causes unemployment

• Costs of asymmetric business cycles can swamp

(any) trade gains

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One Way to Adjust(to Asymmetric Business Cycles)

• Sharing risks

– System of taxes/transfers

– “Robin Hood” taxes rich, transfers to needy

– Relieves unemployment, inflation

• In principle, can do via private sector (international

cross-holdings of assets)

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An Alternative Adjustment Method

• Factor Mobility

– Unemployed workers move to places of high

demand

– Relieves unemployment and inflation

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Mundell’s “Optimum Currency Area”

1. Suppose business cycles are asymmetric, and2. There is a) little risk-sharing, and b) immobile

labor, then3. Gain from using differential monetary policy to

smooth different shocks• Use different monies to adjust to different business

cycles• Evidence within countries (e.g., American

regions)• Evidence across countries (e.g., EMU)

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Fiscal Austerity is not the Solution

• It solves a different problem• Greek problem is poor competitiveness– Manifestations: current account deficit, slow

growth, unemployment– Also true of other “Club Med” (Portugal …)

• Classic example of “asymmetric shock”

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Competitiveness within EMU1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Real Effective Exchange Rate (1999=100)

Germany 100.0 93.3 93.3 94.3 99.4 101.1 99.3 98.6 100.5 101.1 101.6 96.8

Greece 100.0 93.4 94.6 97.5 103.9 106.0 106.4 107.4 109.3 112.4 113.8 113.7

Portugal 100.0 97.6 100.0 102.5 107.2 108.5 108.5 109.1 110.8 111.7 110.9 108.6

Current Account Balance (% of GDP)

Germany -1.3 -1.7 0.0 2.0 1.9 4.7 5.0 6.3 7.5 6.3 5.7 5.7

Greece -5.4 -7.8 -7.2 -6.5 -6.6 -5.9 -7.5 -11.2 -14.3 -14.8 -11.0 -10.6

Portugal -8.2 -10.4 -10.3 -8.2 -6.5 -8.4 -10.4 -10.7 -10.1 -12.6 -10.9 -9.9

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Bottom Line

• Greece has a fiscal problem– But solving it (if possible) won’t restore growth

• Real problem: poor competitiveness limits growth, employment

• No easy solution for that• Hence … more serious crisis inevitable– Could easily be worse than Lehman

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Second Potential Threat:Global Imbalances

• America’s Current Account Deficit– 2006: $811.5 billion deficit (!)• >6% of American GDP• Implies annual Capital Inflows of $2700 per person

annually (!)

– Almost all Goods (Services in surplus but small)• Small persistent income surplus

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Causes

• Some Dispute among Economists• Still, Low American Savings chief reason– Personal Savings very low lately, often negative – Public Sector also dis-saving (Federal deficits)

• Lack of Investment outside US also possible issue

• Poor Savings opportunities outside US?

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US Current AccountDeficit: Sustainable?

• Size of Deficit unprecedented for America• Also unprecedented for “Anchor” country• US now taking over 75% of all global savings

flows• Capital running “uphill” from poor to rich (!)• Growing US external debt

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Things that Can’t Go OnForever … Don’t

• US current account imbalance has shrunk dramatically since 2006

• Now ≈ 3% GDP (lower, but high)• Which leads us to Asia …

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Asian Development Strategy

• Asians take Exchange Rate Policy Seriously• Almost all East Asians manage currencies, will

continue to do so• Part a Legacy of Asian Crisis of ’97-’98• Mostly a Development Strategy …

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China Especially

• Chinese Communist Party Needs Growth to Survive Politically– Growth is Required to Absorb Massive

Unemployment in Chinese Countryside

• Agricultural Peasants Must Be Transformed Into Manufacturing Workers– Exports Provide Only Possible Outlet

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Implications for West

• China had incentive to maintain under-valued exchange rate– Under-valuation the key to rapid export growth– Right in theory– Effective in practice (past twenty years!)– Hence rapid accumulation of US$ reserves, as

China maintains under-valued peg to US– Reserves act as “collateral”, encourage FDI

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Special Role of USA

• US is issuer of $, global reserve currency• East Asians fixes against US$• US is largest, most open economy• US willing to handle large, persistent current

account deficits

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Calm Breaking Out?

• Yuan now appreciating in both nominal and real terms; dollar depreciating

• Current Accounts returning to more normal levels

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Current Accounts, Exchange Rates

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Current Accounts (% GDP)

China 1.7 1.3 2.4 2.8 3.6 5.9 8.6 10.1 9.1 5.2 5.2

US -4.2 -3.9 -4.3 -4.7 -5.3 -5.9 -6.0 -5.1 -4.7 -2.7 -3.2

Exchange RatesChina,Real 108.5 113.2 110.6 103.3 100.5 100.0 101.6 105.6 115.3 119.2 118.7

Yuan/$ 8.28 8.28 8.28 8.28 8.28 8.19 7.97 7.61 6.95 6.83 6.77US, Real 107.8 113.9 113.6 106.4 101.4 100.0 99.4 94.7 91.0 95.1 91.4

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Bottom Line

• Worry about Europe, not China

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