University of Piraeus

Professor El Thalassinos, Chair Jean Monnet http://www.jeanmonnet-emu.eu

The EURO & the Sovereign Debt Crisis:An International Political Economy

Approach

Aim

• To highlight the EU’s Political Economy Dimension.

• To underline the EMU’s Political Economy Aspect.

• To examine the relation between the sovereign crisis and EURO’s operational framework.

• To approach EMU’s shortcomings that have contributed to today’s EU crisis.

Central Argument

• EURO’s Inadequacies and problems stem from EU’s political nature.

• EURO is a project of profound political implications.

• EURO was decided to be implemented, primarily, on political criteria.

• EMU is a project that has raised the stakes for EU members very high.

Setting the Stage…

• The EU is by far the most successful peace project in history.

• EU’s development is a history of incremental approach towards: Political integration; Economic integration;

• Strategy: promoting further integration through the attainment of specific economic goals.

• Result: development of institutional bonds and common interests.

History’s Lessons…

• Numerous attempts throughout European history to unify the continent.

• EU represents a fundamental break with Europe’s violent past.

• Zollverein (GER): the roots of the EU’s (E.E.C.) theoretical foundation. Ironically enough, a French (Schuman & Monnet) conception of establishing a common market (due to fear of the German power) is based on the German culture of a decentralized federal system of economic and political management.

Stages of European Economic Integration

• Preferential Trade Area• Free Trade Area• Customs Union• Single Market• Monetary Union• Fiscal Union• Full Economic Union/Integration

• The EU has come long way to reach the stage of the Monetary Union, evolving in a volatile international political & economic environment for more than 50 years.

The Road to the EMU• European Economic Cooperation: basis and institutional

framework had been laid down from:a) Treaty of Paris (1951) – ECSCb) Treaties of Rome (1957)c) Hague Treaty (1958) d) Treaty of Brussels (1967)

• Monetary Union - Early Attempts and beyond:

- 1970: Werner Report- 1970s: Collapse of Bretton Woods Regime → the European Monetary Snake (Basle Accord)- 1979 – EMS & ERM I: The DM & Bundesbank at the centre →culture of Monetary Discipline and Monetary Institutions - 1986: Single European Act- 1989: Delors Report- 1992: Treaty of the EU, Maastricht Convergence Criteria and Monetary Union Structures.Goals: relatively stable prices, healthy fiscal sector, healthy monetary conditions, stable Balance of Payments for each country that wished to participate.

The Political Economy Context of the EMU• General Context:

a) Decline of the US hegemony & emergence of new actors.b) Rise of Economic & Monetary Issues in Foreign Policy Agenda. c) Emergence of GER as global Economic power.d) GBR & FRA underlining their role in international conflicts

• Result: a new political & economic environment within which the EU was called to evolve. In this context, the DMark represented for the Germans the absolute symbol of national pride, that were reluctant to give up in favor of a common currency.

• The EMU brings to the foreground EU’s perennial questions:- Supranationalists (Federalists) VS Intergovernmentalists- Economists VS Monetarists - Trade off between GER vs FRA + GBR

• Turning Point: German Unification – FRA promotes the Monetarist view of the EMU attempting to institutionalize even more the German participation in the EU putting a Unified Germany within a European context. In fact, Francois Mitterrand had set the acceptance of the Maastricht Treaty as a prerequisite to the German’s for giving his approval to Germany’s Unification

• Three Phases of the EMU:a) Coordination of Economic Policy between member statesb) Achieving Economic Convergence (economic cycles broadly in steps)c) Adoption of the common currency (EURO)Have all the aforementioned taken place at order of appearance?

• Centralized Monetary Policy

• Coordination but Decentralized Economic and Fiscal Policy

• Independence

• Goals of the EMU (according to Classic Economic Theory): 1) Price Stability = Low Inflation (prices and wages)2) Economic Growth and Development3) Increase of Employment

Remarks on the EMU

Significance of Monetary Union• Political Significance

While in 1995 only few (two) member states could claim that they fulfilled the Maastricht criteria, in 1997 eleven member states were considered as eligible for the EMU…

• Economic Significance- Motives for establishing a Monetary Union: a) Increase of Monetary stability & Economic Security against speculation. b) Increase of Financial Credibility in International Markets. c) Boosting of the Single Market that precedes a Monetary Union. d) Increase of Economic power and independence

• Economic Rationale of a Monetary Union- Elimination of exchange rates fluctuations & devaluations- Greater price transparency - Reform of labor markets & opening up of economies to greater competitionResults:- More efficient allocation of resources- Reduction of Cost of Capital- Boost of Productivity & Investments- Greater Prosperity

O.C.A. Theory• Optimum Currency Area (O.C.A.) Theory (Robert Mundell et al)

- An Optimum Currency Area is a geographic region that adopts a single currency for optimizing economic efficiency.- General Criteria for the establishment of an O.C.A.a) Production Flexibility including Labor and Capital Mobility - Price and Wage Flexibility→ Convergence;b) Openness of the Participating Economies;c) Financial Integration: a Risk Sharing System & monetary transmission mechanisms;d) Similar Business Cycles and Real Economic Convergence;e) Political Integration: Commonality of Destiny.- Endogenous Criteria for a member state to participate to an O.C.A.a) Volume of Trade of a Candidate Countryb) Diversified Production of a Country’s Economyc) Fiscal Policy Coordination but Decentralizedd) Similarity of Structural Characteristics of member economies

OCA – Benefits & Costs1) Benefits• Elimination of Currency Risk and Financial Uncertainty

- Predictability of Price levels - Price mechanism and markets function more effectively - Reduction of hedging costs - Facilitates the function of money markets and capital markets

• Reduction of Foreign Exchange Costs = Increase of International Trade

• Convergence and Reduction of Prices of goods and services.• Decreasing of Foreign Exchange Currency level of reserves

available for interventions in currency markets.• Decrease of Interest Rates and enhancement of Competition • Elimination of Speculation towards weak national currencies.• Financial Solvency at the cost of ceding part of sovereignty

2) Costs• Loss of independent national monetary & exchange rates

policy

But enough with Theory…Is the EMU an OCA?

1) Labor and Capital Mobility: capital mobility is quite high - labor mobility relatively low

2) Openness of the Participating Economies: The EURO has a significant trade effect (increased trade by 5% to 15% in the Eurozone) without “fortress Europe”

3) Risk Sharing System – Fiscal Redistributing Mechanism: great politico-economic implications for the Eurozone.Key Questions: a) GER has reaped the benefits from the establishment of the common currency. Is it the time also to bear the hegemonic costs of the EURO = Fiscal Redistributing Mechanism + Eurobond. b) Are other European ready to accept mutuality on EU countries’ debts?- EMU and Bail-out Mechanism (ESM, EFSF)

4) Business Cycles & Economic divergences

What is still missing?

Economic Convergence (real economy) Price Convergence Elimination of Structural Rigidities in product and labor

markets Increased Labor Mobility Openness of Economies Full Integration of the participating economies Sound management of public financing. There is lack

of fiscal discipline, despite the SGP. Fiscal Transfer System A European Monetary Fund (ESM, EFSF ?) Sense of common supranational destiny

Positive Effects of the EURO

• Trade Creation VS Trade Diversion: all empirical research shows that intra-EMU trade by 5% to 10%, and without trade diversion vis-à-vis the rest of the world (no fortress Europe).

• Lower Transaction Costs• Less Uncertainty in Trade from FX fluctuations• Price Transparency and Less Segmentation of

market→ foster competition and price convergence & co-movement

• Capital Market Integration increasing competition and opening up new sources of financing for companies.

• Economies of Scale due to larger market size• Openness of economies has been facilitated as

cross border mergers have increased steadily.

Still, the EURO per se is neither Good nor Bad

• EMU trade effect may not be attributed only to the elimination of exchange rates uncertainty : increased credibility of ECB; price transparency; higher macroeconomic stability; reduction of trade costs; progress of Common Market.

• Some countries were better placed to reap the trade benefits from a common Currency. This depends on several factors: High Level Trade Openness: greater exposure to trade→

greater benefits Exchange Rate Volatility: higher volatility prior to EMU,

greater benefits due to decline of exchange rates uncertainty.

Market Flexibility and Reforms: Competitiveness = higher flexibility in shifting resources, adaptability of production, limiting entry and exit costs→ higher benefits.

Structural Characteristics of member states’ economies: economies that have solid economic and productive structures, healthy bureaucracy and are export their products benefit more.

USA as an OCA – Enabling Factors(Sources: www.pimco.com; Robert Mundell speech in Jean Monnet Global Conference 11/2011)

• Several US states have defaulted in the past. Yet, it was never considered as a dollar problem but rather a fiscal policy problem.

• Three developments allowed the U.S. to become a full-fledged monetary union: the drafting of the U.S. Constitution, which gave Congress the

power to coin and regulate money; Creation of the Dollar: the establishment of the Federal Reserve

and the Fed’s issuing of Federal Reserve Notes in 1914; Creation of the Central Bank: the introduction of the Banking Act

of 1935. Consolidation of States’ debt into the US debt. States were then

sovereign to run their own debts and budgets.

• Other fundamental factors: Dividing but overlapping sovereignties on fiscal policy Residual powers were left to states. Although historical practice is not in favor of bail outs, American

constitution does not prohibit it. Automatic changes in fiscal transfers between regions and

central government through a progressive tax system that closely related to income levels. Such a mechanism does not exist in the EU as it qualifies as a major step towards further integration.

But is there a perfect OCA?

• Kouparitsas M. (Federal Reserve Bank of Chicago, 2001), “Is the US an Optimum Currency Area? An empirical Analysis of Regional Business Cycle” He applied in his analysis the division of the US

into the eight regions as the Bureau of Economic Analysis does. He found that five of the eight regions of the country satisfied Mundell's criteria to form an Optimal Currency Area. However, he found the fit of the Southeast and Southwest to be questionable.

• Alesina-Baro-Tenreyro (Harvard University, 2002), “Optimal Currency Areas”, “Optimal Currency Areas” “…based on the historical data on inflation, trade,

and comovements of prices and outputs, we argued that there exist well-defined dollar and euro areas…the adoption of another’s country’s currency increases bilateral trade and raises the co-movement of prices.”

USA vs EMU as an OCA 1995-2010 (1)(Sources: www.pimco.com; www.ecb.int)

• Aggregate inflation and growth differences are not too dissimilar.

• Since 1995, U.S. average real GDP has been only 0,5% higher than Europe’s real GDP.

• European unemployment rate was 3% higher than the USA’s over the same period. 

• The difference between the U.S. and Euro labor markets can be attributed to specific factor contribution to real GDP growth.

• The U.S. scores much higher in terms of labor productivity, labor mobility and wage flexibility.

• Factor specialization index: the extent to which a country's production pattern differs from those of a comparison group of countries.

• Krugman’s research showed that the higher the degree of specialization, the more synchronized business cycles could become between countries.

• Relatively low factor specialization for the EU relative to the U.S. since early 2000.

USA vs EMU as an OCA 1995-2010 (2)(Sources: www.pimco.com; www.ecb.int)

USA vs EMU as an OCA 1995-2010 (3)(Sources: www.pimco.com; www.ecb.int; Speech by Jean-Claude Trichet, President of the ECB, Jackson Hole, U.S.A., 08/2011)

• Trichet: similar dispersion in Unit Labor Costs (ULC) in areas with both high and low wage costs, a reflection of differences in economic diversity and competitiveness.

• 2006 paper “How Wages Change: Micro Evidence from the International Wage Flexibility Project”: average real wage rigidity, is very low for the U.S. (10%), but much higher for the eurozone (25% avrg).

• The density of labor unions and bargaining power is high in the EU (45%) and low in the US (20%).

• U.S. the least rigid in wages, while the eurozone experiences far greater rigidity.  

USA vs EMU as an OCA 1995-2010 (4)(Sources: www.pimco.com; www.ecb.int)

• The eurozone has lacked mobility of labor for some time (OECD Survey: 4% of the European workforce has lived and worked in a different member state.

• Since 2000, the average labor mobility has been a lot higher in the U.S. and than in the European Union.

• Qualitative difference between US-EU: cultural diversity and language barriers

USA – EU: faced similar problems

• USA: Federalism VS Confederalism: States’ Rights and the Civil War

• EU: Federalists VS Intergovernmentalists States’ rights and the limits of European

Integration

• USA: States’ Default: Consolidation of debt

• EU: States’ Default No structures existed when the crisis broke out

– imperative need of Economic Governance framework (set up of ESM, EFSF)

The leap forward→ EUROBOND, it seems inevitable, that’s why countries like GRE have to be present and economically “alive” when that development takes place.

…but in the end of the day…Source: (www.pimco.org)

• Mundell (O.C.A.): Different countries & different national currencies: Surplus

Countries allow high inflation→ Deficit Countries enjoy increased employment

Many regions & a single currency: Central Monetary Authorities reduce inflation (contractive monetary & fiscal policy)→ high unemployment in the deficit regions.

What is needed: coordination among central banks to avoid unemployment and inflation whereby surplus countries help to adjust deficit countries.

• Decentralized policy: economies to have an effective adjustment mechanism to absorb shocks.

• U.S. has more optimum currency area features than the Eurozone. But it does not necessarily mean higher and more sustainable economic growth. Key for the EMU is to eliminate labor market rigidities.

• Structural reform: it has been very modestly implemented in the eurozone.

• The eurozone debt crisis has one “advantage” as it may push for quicker reforms.

EMU: Fostering Political Integration through full Economic Integration

• First, European monetary integration has been part of the broader process of economic and financial integration;

• Second, European integration is a political process;

• Third, economic, financial and monetary integration has evolved gradually over a long period, and is still evolving (adjustment);

• Fourth, the advancement of European integration has proceeded hand in hand with the advancements of economic theory.

Core and Periphery in view of the Sovereign Crisis

• Powerful EU Economies: eager to develop a large and competitive Eurozone, allowing less solvent EU nations to enjoy increased financial credibility;

• Periphery states: large infusions of liquidity (unprecedented access to credit due to cheap cost of capital). BUT: "productive capacity" of the periphery was limited by rigid labor markets and inefficient allocation of those financial resources.

Timeline of EU Sovereign Crisis and Responses(Source: ECB and various)

Crisis Event• 9/2008: Lehman Brothers files for Bankruptcy

• 4/2010: GRE seeks financial support

• 7/2010: Banks stress test results

• 11/2010: IRL seeks Financial Support

• 4/2011: POR seeks Financial Support

• 6/2011: GRE situation exacerbates

EU Response• 10/2008: ECB activates extra liquidity & refinancing

measures• 5/2010: EC, ECB, IMF support GRE

6/2010: ECB sets up EFSF • 07/2010: ECB announces stricter rules on bank

collaterals

10/2010: SGP to be tightened

• 12/2010: EU, IMF rescue package for IRL agreed

12/2010: Go ahead for ESM from EU leaders

3/2011: Euro area agrees on “Pact for the Euro• 5/2011: EC, ECB, IMF support POR• 9/2011: ECB enhances liquidity operations ($US)

10/2011: EFSF becomes fully operational

10/2011: ECB announces second covered bond purchase program

11/2011: EU Council strengthens economic governance

12/2011: ECB supports bank lending & money market activity

2/2012: ECB approves eligibility criteria for credit claims

A medal commemorating

Germany's 1923 hyperinflation

The Role of Germany – Why is it so warm Advocate of strict Fiscal Policy Rules?

• Hyperinflation of the Weimar Republic:

"On 1st November 1923, 1 pound of bread cost 3 billion, 1 pound of meat 36 billion, 1 glass of beer 4 billion."

• Bond Markets: their lethal enemy, Inflation

• The DM: ultimate symbol of national pride for GER

• Free riders problem• German Unification: power shift• Germany: the undisputed economic

dominant power of Europe = regime builder – Fiscal Pact and general management of the Crisis

• It is not whether the German’s dominate within the EU, but rather how do they exert their supremacy.

Role of Germany …and the Greek Problem

• Strict policy→ laying down policy rules so as to ensure that no other EMU country will walk down the path that the Greek government followed: “…we reiterate our decision taken on 21 July 2011 that

Greece requires an exceptional and unique solution.”

• The EU has set certain fiscal goals, explicitly avoiding to dictate specific measures: “… The mechanisms for the monitoring of implementation

of the Greek programme must be strengthened, as requested by the Greek government. The ownership of the programme is Greek and its implementation is the responsibility of the Greek authorities.”

• Still, the economic measures taken in Greece are not towards the right direction as the Greek Government has failed to actively promote structural changes in the Greek economy and reform drastically the public sector, both being imperative to be realized. On the contrary, it has severely hit low & middle class creating a lot of societal strain and following a reactive policy which followed no specific strategic plan, but only aimed to satisfy Troika’s goals…

Fiscal Status in the EMU (2010)…Sovereign Crisis is a European Problem!

• Maastricht Economic and Monetary Convergence Criteria for joining the EMU:

1) Inflation: < 1,5% higher than the average of the three best performing (lowest inflation) member states of theEU.2) Long Term Interest Rates: < 2% higher than those in the three lowest inflation member states.3) Exchange Rates Stability: applicant countries should have joined the ERM II under the EMSfor two consecutive years and should not have devalued their currency during that period.4) Fiscal Criteria: - Annual Government Deficit: ratio of annual government deficit to GDP < 3% at the end of the preceding fiscal year. - Government Debt: ratio ofGovernment debt to GDP < 60% at the end of the preceding fiscal year• The Euroarea has been

demonstrating weak economic activity over the last few years.

EMU members’ exposure to Greek Bonds (2011)

Greece • Country's total debt: €329bn• Total debt as percentage of

GDP: 165.6%• Greece is heavily indebted to

all Eurozone countries. It owes nearly $74 billion to Germany and France, with the latter being heavily exposed to the Greek debt.

• FRA & GER have reduced their exposure by 40 bn Euros since last quarter 2011…

• 4/2010 – GRE resorts to Troika support: race against the clock between the Greek side and those parties exposed to the Greek debt.

Greece left to Default?• Great Exposure of European Banks and Governments to Greek Bonds; the Banks

are the blood lines of a country’s economy providing the necessary liquidity for economic development.

• The Risk of Contagion and the Domino effect; (GRE Banks shrinking, AUSTR banks exposed to HUNG Banks, ITA Banks exposed to AUST banks and so on)

• Germany dependence on EMU’s well being due to export propelled growth Thus, leaving Greece to Default does not appear to be a realistic

option…

• YET, “Pacta Sunt Servanta” – Greece has violated this “axiom”, fuelling distrust by its EU partners

• EU sources: “The roots of Greece's fiscal calamity lie in prolonged deficit spending, economic mismanagement, government misreporting, and tax evasion.”

• The core issue in Greece is not about implementing further austerity economic measures, but rather it is about rationalizing the Greek economy’s structures and promoting economic development measures.

• Greece’s sovereign debt crisis is the symptom rather than the cause of its economic crisis. In fact, even though several rescue packs have been agreed to be “administered” to the Greek Economy, its debt ratio to the GDP will continue to be above 120% in 2020, due to its GDP contraction (2011: -7%).

• If Greece does not actively promote the necessary structural changes in its economy, then it will be obliged to voluntarily leave the EMU, being surpassed by contemporary developments in the EMU.

• Greece needs to restore its credibility both as a state towards its own citizens, as a reliable EU partner and as a solvent International Economic Actor. Greece has to earn back its partners’ trust!

• At the same time, major EU partners have to cease making destructive and provocative statements that undermine Greece’s international economic position and its recovery & to take the necessary leap forward towards a fiscal and political Union (Eurobond).

• What is needed is more Europe rather than less Europe.

Concluding Remarks (1)• The EU is by far the most successful peace project in history.• EU’s development is a history of incremental approach towards economic

and political integration.• EMS and ERM I laid the foundation towards the EMU and the Maastricth

Treaty• The EMU brings to the foreground EU’s perennial questions:

- Supranationalists (Federalists) VS Intergovernmentalists- Economists VS Monetarists - Trade off between GER vs FRA + GBR

• Three Phases of the EMU:a) Coordination of Economic Policy between member statesb) Achieving Economic Convergence (economic cycles broadly in steps)c) Adoption of the common currency (EURO)Have all the aforementioned taken place at order of appearance?

• Goals of the EMU (according to Classic Economic Theory): 1) Price Stability = Low Inflation (prices and wages)2) Economic Growth and Development3) Increase of Employment

Concluding Remarks (2)• Motives for establishing a Monetary Union:

a) Increase of Monetary stability & Economic Security against speculation. b) Increase of Financial Credibility in International Markets. c) Boosting of a Single Market that precedes a Monetary Union. d) Increase of Economic power and independence in the International Political and Economic arena.

• Economic Rationale of a Monetary Union- Elimination of exchange rates fluctuations & devaluations- Greater price transparency - Reform of labor markets & opening up of economies to greater competitionResults:- More efficient allocation of resources- Reduction of Cost of Capital- Boost of Productivity & Investments- Greater Prosperity

Concluding Remarks (3)• Is the EMU an OCA?

Labor and Capital Mobility: capital mobility is quite high - labor mobility relatively low

Openness of the Participating Economies: The single currency has increased trade by 5% to 15% in the Eurozone

Risk Sharing System – Fiscal Redistributing Mechanism – Bail out Mechanisms: great politico-economic implications for the Eurozone. Fiscal Union→ Political Integration

Similar (Synchronized) Business Cycles and Economic Characteristics of the Participant Economies: European economies are substantially diverse.

• But is there a perfect OCA? There exists clear Euro area and Dollar area, but neither of them

fully fulfills the OCA theory’s criteria. Still, U.S. has more optimum currency area features than the

Eurozone. But, even though the U.S. is (presumably) closer to an optimum currency area than the EMU, it does not necessarily mean higher and more sustainable economic growth. Key for the EMU is to eliminate labor market rigidities.

Still, the EURO has already some positive effects. But the EURO is neither good nor bad per se. It offers the chance to economies that are better organized and structured to reap the benefits from the elimination of exchange rates.

Concluding Remarks (4)• Today, the EMU poses clear political and economic challenges as the

EMU leaders are called to take the next bold step towards fiscal integration, which points clearly to greater political integration. Thus, it is the time of truth for all participants concerning their willingness and their determination towards the vision of a more integrated Europe.

• The EMU offered to GER and more advanced economies a larger internal market, while at the same time it offered to the periphery’s economies the chance to enjoy increased credibility that was translated through access to cheaper capital and increased credit lines.

• However, GRE failed to use this facilities to enhance its economy’s productive base. Thus, when the markets started treating these economies in a diversified risk manner, credit availability became scarce, and GRE nearly defaulted.

• GER is not willing to let disadvantaged economies to put the EURO at risk for historical, political and economic reasons. However, if the cost of supporting the EURO is increased above the benefits that GER reaps, then it would be tempted to be the first country to abandon ship…

• GER has a long history of fiscal discipline that is dictated by fear of high inflation. However, while laying down strict rules is a prerequisite for the EURO’s management, still economic development is a goal that eludes the EMU today.

• Today, not many EMU countries fulfill the Maastricht criteria, revealing that the sovereign debt problem is a European one and that fiscal discipline alone does not suffice for the EMU to prosper.

Concluding Remarks (5)• The Greek economy represents the weakest link of the EMU. Its

qualitative and quantitative improvement is not only to the EMU’s benefit, but foremost for the country’s well-being.

• Greek Economy may not have a much, worldwide, in terms of rigidity… Greek economy is called to reset and be founded on new basis by promoting a new economic model where the state would have a strategic role of channeling economic actors activities towards fields that the country has relative advantage, rather than being itself a business partner, as it used to be over the last 30 years.

• For this to be realized, the necessary break up with the past is needed clashing with unproductive interest groups.

• Thus, more austerity measures would add nothing to Greece’s endeavor to recover; rather, they would exacerbate present recession. Instead, what is needed is the setup of new economic management structures by the government and of a clear and stable economic, tax, political and constitutional framework that would constitute a reliable environment for attracting investments and promoting business practice.