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THE EURO CRISIS – WHAT HAVE WE LEARNED AND WHAT CAN BE DONE?
Christopher A Pissarides
Regius Professor of Economics
London School of EconomicsEssex 50th birthday celebrations, 12 June 2015
1
The Eurozone crisis
• The European Union is clearly not delivering what it promised with the single currency
• What is needed to bring it back to robust growth?
• Does the fault for the prolonged crisis lie with the structure of labour markets or with monetary and fiscal policies?
• Will argue that crisis is due to mismanagement of a single currency when the optimal criteria for an optimal currency area are not satisfied
2
Labour markets in crisis?
• European labour markets have become inflexible
• Many reformed: UK in the 1980s, Netherlands in early 1990s, Germany in 2002-2005
• Reforms are essential in Europe for competitiveness and adoption of new technologies
• Debt management and inflexible labour markets got confused with bad outcomes for each
3
Optimal Currency Area?
• OCA requires similar economic structures and business cycles to reduce the risk of different policy requirements
• The crisis exposed differences due mainly to relative size of construction sector and debt
• It requires labour and capital mobility to correct imbalances that may require different policies
• Although free, these don’t work as correction mechanisms
4
Optimal currency area
• Fiscal transfers can also offset imbalances, often recommended in addition to factor mobility
• But the Eurozone does not allow them – Maastricht criteria meant to remove the need for them
5
6
Fiscal transfers have been critical in countries where monetary union worked
• United States when West opened up: infrastructure was provided with East Coast money
• German unification: East Germany was kick-started with West German money
• In both cases we had political union!
• EZ is using them as the main tool to correct imbalances between members: ESM, various rescue packages, ECB QE
Are economies in the Eurozone similar to each other?
• Originally yes - Greece was probably the first country to be admitted with less similar structure (more agriculture, more trade with Balkans and East)
• But recent crisis exposed some unanticipated dissimilarities between members with bad consequences
• Ireland, Spain, Portugal and Cyprus grew very large construction sectors
• Smallest construction sector about 6% of employment before the crisis and majority below 8.5%. Greece at 8.8% but other “crisis” countries 10.7-13.3%
7
Construction employment shares, 2007 (in red: program countries)
NETSLV
GER
BELDEN
MAL
NOR
AUT
EURO ITA
GRE
CZECYP
LAT
SPA0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
8
Implications
• Crisis started in the housing sector – so countries with bigger construction sectors received a bigger shock
• Banks had over-extended loans in this sector; governments guaranteed them to avoid run on the banks
• So the negative impact of the housing shock in these countries was reinforced by public debt explosion that forced contractionary fiscal policy
9
Why no debt crisis in the Baltics and why in Greece?
• In the case of the two Baltic states their large construction sectors seemed to be justified by their large growth rates following transition
• In the case of Greece the problem was not so much the bursting of a construction bubble but a large public debt accumulation prior to crisis
10
Correlation between construction sector size and growth rates
0 1 2 3 4 5 6 7 8 9 1000
02
04
06
08
10
12
14
R² = 0.197477295735625
Average growth rate 2001-07
Co
nst
ruct
ion
sh
are
2007 CYP
EST
11
POR
SPA IRL
LAT
Correlation between construction sector size and growth rates
0 1 2 3 4 5 6 7 8 9 1000
02
04
06
08
10
12
14
R² = 0.3787432511015
Average growth rate 2001-07
Co
nst
ruct
ion
sh
are
2007 CYP
EST
12
LAT
Labour market responses
• With flexible exchange rates, when big negative shock hits a sector like construction demand for imports falls and exchange rate depreciates
• In a common currency area we need other corrections
• Out-migration
• Fiscal transfers
• Failing these “internal depreciation”, namely, wage reductions
13
Internal depreciation
• Forced on programme countries
• But unemployment needs to rise substantially to trigger the internal depreciation
• and it did, making the recession worse
14
Unemployment change 2007-2012
GE
MA AU
RO NO LU FR UK SK DE EU EZ LA IT LI CYG
R
-5
0
5
10
15
20
25
15
Did recession trigger the right labour market response?
• Nominal and real wages fell everywhere in the periphery but only in Greece to a non-trivial degree: 17% fall in real average earnings
• Although there was some deflation prices largely held up
16
Real average earnings 2012(2009=100)
own Relative to Germany
Ireland 97.0 94.2
Italy 97.9 94.0
Spain 96.8 95.1
Portugal 90.6 87.9
Greece 82.5 80.1
17
Did wage adjustments bring the right results?
• Biggest failure of the combined programmes of debt reduction and economic restructuring
• Massive fiscal retrenchment was reinforced by real wage reductions that spilled out to the whole economy
• Classic Keynesian response of labour markets: negative fiscal multipliers reinforced instead of being offset by wage reductions
18
Why didn’t wage reductions work?
• For standard Keynesian reasons: deflation does not get a country out of a recession, especially one with large debts
• Wage and pension reductions accompanied by a fall in government spending, tax rises and dysfunctional (home-biased) banks reduce aggregate demand catastrophically
• The real value of debt rises; the troika forces further spending cuts to reduce the debt to GDP ratio; deflation gets worse
• A vicious circle that leads to more debt and unemployment
19
Labour markets at fault?
• Ireland has flexible labour markets: its aggregates are similar to other countries hit by the construction shock
• The key reason for Europe’s labour markets not working is the deflationary shock following the debt crisis
• Compare Ireland (flexible labour markets) with Spain (inflexible labour markets)
20
GDP per head2007=100
2007 2008 2009 2010 2011 2012 201375
80
85
90
95
100
105
Ireland Spain
21
Employment rates2007=100
2007 2008 2009 2010 2011 2012 201375
80
85
90
95
100
105
110
Ireland Spain
22
Monetary policy
• The obvious alternative to fiscal austerity is expansionary monetary policy
• The ECB needed to create more inflation that would depreciate the euro and reduce the real burden of the debt; err on the upside on its inflation target
• Bank of England followed similar policy when Coalition government imposed debt-reduction fiscal policies in 2010
• ECB eventually acted (March 2015)
23
Could the ECB balance them out?(Inflation target “just below” 2%)
December 2014 figures (all per cent)
Inflation unemployment
Germany 0.8 4.9
Southern periphery
-0.2 18.6
Eurozone 0.4 11.5
24
ECB policies
• Given unemployment rates, correct monetary management of common currency area required erring on the upside, not the downside
• ECB tolerated 0.4% inflation with a target of just below 2%, it could have tolerated 3%
• Low debt countries had nothing to fear from it, high debt countries would have benefited
25
Debt burdens
• Debt burdens are tolerable now because of very low interest rates and help from IMF and ECB/Commission
• But when interest rates start to rise they will become unsustainable – inconsistent with fast growth
• Need to find a way of reducing the debt burden
• This inevitably will involve some kind of “haircut”
26
Investment and growth
• But more importantly, we need more investment and productivity growth
• Germany doing well in Europe – but the average EU performance is appalling
• Need to find a way of financing investments, e.g., draw distinction between money lent for investment and money lent to finance budget deficits
• Otherwise we will keep falling behind
27
Domestic R&D, 2012
EU-28 GERMANY USA JAPAN CHINA0
0.5
1
1.5
2
2.5
3
3.5
business government higher education
% o
f G
DP
Fixed capital formation, private
US EU Spain Portugal Ireland Greece0.0
5.0
10.0
15.0
20.0
25.0
30.0
2007 2012
% o
f G
DP
Fixed capital formation, public
US EU Spain Portugal Ireland Greece0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
2007 2012
% o
f G
DP
Labour markets
• Labour markets are not to blame NOW but don’t lose sight of the fact that monetary union requires flexible labour markets
• Many countries, especially in the South, still lack flexibility
• Recent structural reforms are in the right direction but they are taking time to have a positive impact and they need the cooperation of all social partners
31
German reforms
• The German reforms of 2002-05 tool place in favourable conditions and still had their impact 4 years later
• German officials point out that it was great help that rest of Europe was growing and they broke the Maastricht deficit criteria to help implement the reforms
• Exactly what Greece and the others are not allowed to do now!
32
Future of Europe
• Do the Eurozone countries have the political will to cooperate further to restore balance in economic performance?
• If not, future of Eurozone and EU bleak
33