1
THE EURO CRISIS – WHAT HAVE
WE LEARNED AND WHAT CAN BE
DONE?
Christopher A Pissarides
Regius Professor of Economics
London School of Economics
Essex 50th birthday celebrations, 12 June 2015
2
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
3
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
4
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
5
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
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
7
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%
8
Construction employment shares, 2007
(in red: program countries)
14.0
12.0
10.0
8.0
6.0
4.0
2.0
NET
TUR
SLV
SWE
GER
FRA
BEL
POL
DEN
FIN
MAL
SWI
NOR
USA
AUT
UK
EURO
LUX
ITA
HUN
GRE
ICE
CZE
SLK
CYP
POR
LAT
EST
SPA
IRE
0.0
9
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
10
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
11
Correlation between construction sector
size and growth rates
14
Construction share 2007
SPA
IRL
EST
12
POR
LAT
CYP
10
08
R² = 0.1975
06
04
02
00
0
2
4
6
Average growth rate 2001-07
8
10
12
Correlation between construction sector
size and growth rates
Construction share 2007
14
EST
12
LAT
CYP
10
08
R² = 0.3787
06
04
02
00
0
2
4
6
Average growth rate 2001-07
8
10
13
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
14
Internal depreciation
• Forced on programme countries
• But unemployment needs to rise substantially to trigger
the internal depreciation
• and it did, making the recession worse
GE
TU
MA
JA
AU
PL
RO
BE
NO
FI
LU
CZ
FR
SW
UK
HU
SK
NE
DE
US
EU
ES
EZ
SV
LA
BU
IT
PR
LI
IR
CY
SP
GR
15
Unemployment change 2007-2012
25
20
15
10
5
0
-5
16
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
17
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
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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
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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 (homebiased) 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
20
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)
21
GDP per head
2007=100
105
100
95
90
85
80
75
2007
2008
2009
Ireland
2010
Spain
2011
2012
2013
22
Employment rates
2007=100
110
105
100
95
90
85
80
75
2007
2008
2009
Ireland
2010
Spain
2011
2012
2013
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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)
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Could the ECB balance them out?
(Inflation target “just below” 2%)
December 2014 figures (all per cent)
Germany
Southern
periphery
Eurozone
Inflation
0.8
unemployment
4.9
-0.2
18.6
0.4
11.5
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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
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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”
27
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
Domestic R&D, 2012
3.5
3
% of GDP
2.5
2
1.5
1
0.5
0
EU-28
GERMANY
business
USA
government
JAPAN
higher education
CHINA
Fixed capital formation, private
30.0
% of GDP
25.0
20.0
15.0
10.0
5.0
0.0
US
EU
Spain
2007
Portugal
2012
Ireland
Greece
Fixed capital formation, public
5.0
4.5
4.0
% of GDP
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
US
EU
Spain
2007
Portugal
2012
Ireland
Greece
31
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
32
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!
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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