ISS Public Lecture
Six Lessons from the Euro Crisis
for Completing the European Project
The creation of the European Union has proceeded in stages, interrupted by external and internal events. Each setback has led to a change in
the approach adopted by the Member States. The interruption caused by the current crisis is no exception. But, it may represent a crucial
turning point if the lessons of the crisis are not interpreted appropriately. In particular the current crisis provides lessons about the difficulties
involved in dealing with economic imbalances, whether at the regional or the global level. The experience of the Eurozone in providing
asymmetric regional convergence of economies with different backgrounds and performance thus has implications not only for international
reform proposals, but also for the kind of International Financial System that would provide support for developing countries.
Jan Kregel,
Levy Economics Institute
Six Lessons From the EUro Crisis
Every crisis reveals unexpected consequences of economic policies. The current
Euro crisis should be no exception. As EU governments grapple with the crisis,
there are already a number of lessons to be learned.
1. Currency zones don’t solve the problem of International (or Regional) payments
imbalances.
2. The “structuralists” got it wrong, the “economists” got it right
3. There is no French-German Compromise on Policy Convergence
4. Increased Competition reduces inflation, but does not guarantee Growth Convergence
5. A Common Currency does not eliminate the need for internal adjustments
6. The Problem is not the lack of full European Political Union or an EU Fiscal Authority to
Complement the ECB
What is the Problem? For Greece -- For the Euro zone
1. Currency zones don’t solve the problem of International
(or Regional) payments imbalances.
The problems that are now being faced are not new: Remember the global
imbalances and currency turbulence that produced the 1985 Plaza Accord and
then the meeting at the Louvre and finally the free-fall collapse of the dollar?
At that time many economists proposed that the exchange rate instability
produced by the global payments imbalances could be resolved by dividing the
world into unified dollar, DM and Yen currency zones.
However, the introduction of the Euro as an ersatz DM zone does not seem to
have produced the stability that the proponents of such a system had
envisaged, even within the Euro zone.
Indeed, the attempts to manage the dollar-DM-Yen exchange rates in the Plaza
and Louvre Agreements eventually generated an equity and real estate bubble
in Japan whose collapse ushered in decades of stagnation and eliminated any
possibility for the creation of a Yen zone in Asia.
2. The “structuralists” got it wrong, the “economists” got it right
Recall the debates between the “economists” and “structuralists” on the
appropriate means of transforming the European Economic Community into a
unified economic zone.
The structuralists argued that it was important to create common structures and
that eventually the member economies would conform to them. This was a
justification for the Common Agricultural Policy, which created de facto fixed
rates to distribute EU support. The same argument was used in justification of
the introduction of a common currency despite wide disparity in economic
performance in the EU.
The “economists” on the other hand argued that common structures could
only emerge from a long process of economic convergence; the introduction of
the common currency should be the crowning achievement of European
integration. It is impossible to know if this would ever have been achieved, but
it is quite clear that the expectations of the structuralist approach have been
disappointed.
3. There is no French-German Compromise on Policy Convergence
Third, remember the old Exchange Rate Mechanism (ERM)? It was designed to
remedy the difficulties caused by the speculative capital flows produced by the
persistent policy and growth and inflation performance differences between the
major European countries. The flows were usually into the DM, causing
appreciation and difficulty in domestic monetary policy.
The final structure of the ERM was a compromise between two objectives. France
in particular sought to soften the constraining impact that low inflation in Germany
and real DM appreciation had on domestic activity. Germany on the other hand
sought to use the mechanism to encourage convergence to German monetary and
fiscal policies. This was to be resolved by the introduction of a reference currency
unit, the ECU, with relative large fluctuation bands against national currencies.
However, the ERM was constructed as a bilateral exchange rate grid, substantially
reducing much of the hoped for range of flexibility. Here the economists scored a
clear advantage.
4. Increased Competition reduces inflation, but does not guarantee Growth
Convergence
Recall the Single Market Act (SMA) and Economic and Monetary Union (EMU)
to be introduced in 1992? This was basically an attempt to respond to the
disappointing growth rates and slow pace of convergence by means of supply
side policies to create a fully integrated internal market for goods and services.
The 1988 Cecchini Report claimed that Community income could be increased
by at least 5% as a result of these structural changes to open borders and
increase competition within the Community. This clearly did not happen as EU
average growth rates have continued to decline from 3.2% during the dismal
1970s, to 2.25% in the 1980s to and below 2% in the 1990s.
However, it did produce a decline in inflation rates from over 10 % in the 197080s to below 2% in the 1990s. Paradoxically, the policies only served to
compress demand and produce the nominal convergence of economic
variables required to proceed to monetary union.
5. A Common Currency does not eliminate the need for internal adjustments
Fifth, the introduction of monetary union, in the form of a common currency, was to be the
logical complement of the SMA to ensure that exchange rate changes did not distort relative
competitiveness in the internal market. However, policy and performance divergences have
continued to exist, and German policy to reduce efficiency wages as part of its adjustment to
the debts built up by German reunification, in the presence of higher rates of productivity, have
recreated the same problems of divergent competitiveness as those caused by the pre-ERM
exchange rate misalignments.
Without the expedient of exchange rate adjustments other member states were faced with
the prospect of forcing reductions in their domestic wage levels and domestic purchasing
power or using fiscal policies to offset the losses of sales to domestic producers and keep
growth and employment expanding despite the continuing losses in relative productivity and
competitiveness.
In addition, common interest rate policies, which for many countries were too low for domestic
conditions exacerbated these problems. The result was growing differences in government
debt, and growth and tax yields which are now producing the sovereign debt crisis which is
threatening the survival of the Euro. This is, of course, just the mirror image of the position of
the economists noted in lesson 2.
6. The Problem is not the lack of full European Political Union or an EU
Fiscal Authority to Complement the ECB
Among the proposals to respond to the current crisis:
common fiscal policy,
EU supranational Treasury
debt instrument issued by the European Commission
Larger Share of Commission Expenditure relative to EU GDP
These proposals are not concerned with financing of expenditures of
the Commission, but simply with the creditworthiness of the sovereign
debts accumulated by the individual member states. The argument is
that the problem of the creditworthiness of European government debt
would be solved if there were a more complete political union: EMPU!
EURO Eliminates Zero Risk Assets in EU
The creation of the European Central Bank as the issuer of the
common EU currency meant that the zero-risk sovereign debts of
Euro zone governments where no longer fully sovereign in the
sense that they could always be redeemed by the issue of
additional debt or national currency. With the advent of the Euro,
the debt of national governments became the equivalent of
private debt.
The ability to repay the debt, or even to meet the debt service,
depended on the ability of the government to generate a fiscal
surplus. In the absence of the ability to borrow from the ECB, the
creditworthiness, or sustainability, of government debt, depends
on a fiscal surplus at least sufficient to meet debt service.
INTEREST RATE CONVERGENCE
On entry into the Euro a high debt economy such as Italy should have had a fiscal
surplus higher than a low debt country to achieve an equivalent credit rating. However,
the common interest rate set by the ECB, and the failure of financial markets to price
government debt according to sustainability meant that highly indebted countries saw
their debt service decline, and thus reduce the necessity to run higher surpluses.
Indeed, pre-Euro introduction market speculation to profit from the capital gains on
high coupon debt that was expected to occur with interest rate convergence produced
that result.
Markets thus ignored the large difference in outstanding debt ratios across
countries and accepted that the uniform debt and deficit conditions set in the Stability
and Growth Pact would be honoured. But this eventuality would have meant a
certain path to divergence, not to convergence, of debt ratios and economic
performance.
Risk-Adjusted Interest Rates?
Differential Impact oF Capital Flows
Differential Impact of Capital Flows:




“Northern” economies attracted investments in “productive” sector
“Southern” economies attracted investment in real estate
positive relationship between FDI and trade balances for “North”
negative relationship for the “South”
Accentuated Divergence After Introduction of the Euro:

After 1999 substantial rise in the net inflow of FDI in the euro area.

At industry level:
 positive relationship between FDI in manufacturing sector and the trade
balance in the North
 negative relationship between FDI in non-manufacturing sector and trade
balance for South
 When FDI inflows are channeled to the productive/tradable
(unproductive/non-tradable) sector, this leads to substantial improvement
(deterioration) in productivity and competitiveness in the long run.
Hedge or PONZI FINANCE
For EZ government debt to be risk free, it has to guarantee that it will be
able to meet the debt service out of current revenues. Since the government
cannot create Euros, but only generate them by taxing the private sector,
this means that it must run a fiscal surplus sufficient to cover current interest
as well as paying down debt to reach the SGP limits.
In Minsky’s terms it must be engaged in hedge finance. In the absence of a
fiscal surplus the government must issue additional debt to the private
sector since it is formally forbidden to borrow from the ECB. In this case the
government is engaging in what Minsky called “Ponzi” finance.
The concern of the ECB to introduce ironclad conditions on fiscal deficits is
understandable if it is to respect the prohibition on lending directly to
governments. However, such a policy is also unsustainable, as has been
more than evident in the current crisis.
Respecting Financial Balances
If all governments run hedge profiles, then whatever the maximum debt ratio chosen,
the surplus as a share of GDP cannot fall short of the interest rate paid on the debt.
The ECB’s control of interest rates thus also indirectly controls fiscal policy and
increases its leverage on the level of economic activity. No common security or EU
Treasury is necessary to achieve this result. Indeed, a common Treasury or issue of a
common bond in the absence of the ability of the ECB to lend to it would simply create
a surplus on the aggregate level capable of meeting the debt service on the common
debt.
But this route to stability of sovereign debt does have an impact on the structure of
financial balance sheets. If the government is running a fiscal surplus, then the
balance of the private sector deficit and the external surplus must be sufficient to offset
it, otherwise incomes will be falling. If, as is usual, the private sector and the public
sector are in surplus, then the Eurozone as a whole becomes a gigantic drain on
global demand simply to keep European income levels stable. Or to put it another
way, debt stability depends on global levels of activity. And the Euro creates a black
hole for global demand, which risks creating the kind of financial imbalances it is
meant to eliminate.
Who Will Provide Risk Free Assets to Finance Deficits?
Of course, the problem could be resolved if the ECB were
able to act as the lender of last resort to allow
governments to run fiscal deficits as required to keep
incomes at an acceptable rate of growth, since the
sustainability of the ECB’s debt is independent of its net
income. The solution to the problems of the Euro will not
lie in the prickly problems of political unification or unified
fiscal policy.
What is the Problem?
1. For Greece
Meeting Debt Service: Budget Problem: + Receipts - Expenditures
Internal Adjustment: Competitiveness problem: Reduce wage costs
Building an Export Sector: NO ONE IS DOING THIS
2. For the Survival of the European Union
Globally Sustainable Budget Policies
Everyone cannot run a Surplus
Unless ROW runs a Deficit
Global Imbalances have to be Permanent?
Is There a Solution? Reduce Debt and Deficits?
17

The ability of the Sovereign to
Meet

debt service
Requires increased Tax yields
(T>G).

This requires Private Sector to
Increase
tax payments
Reduce Consumption, Increase saving
CAN THIS BE DONE Without Reducing Income??
The Debt Crisis in Greece and the Eurozone: Is there a Solution?
Is There a Solution? Reduce Debt and Deficits?
18

The ability of the private sector to
repay
debt
increase tax payments

Requires private sector credits
Households:
Y-C > 0
Firms: Profits > 0

Combined Private sector: S> I
The Debt Crisis in Greece and the Eurozone: Is there a Solution?
Minsky: How will borrower Repay?
19
Private Sector:
 1) Hedge:

a)
S>I
2) Speculative: some
more debt
 3) Ponzi: only more
debt, sell assets

Sovereign:
 1)Hedge:

 T>G
2) Speculative: some
more debt
 3) Ponzi: only more
debt, asset sales

Macro Economic Balance 0 = (S-I) + (T-G) + (X-M)
The Debt Crisis in Greece and the Eurozone: Is there a Solution?
0 = (S-I) + (T-G) + (X-M)
20


T-G>0
 S-I
________________
 2 Private Sector Repay

S-I
<0
__________________
 3 Private & Govt Repay

S-I

Private Sector:
1 Sovereign Repay
> 0 &T-G > 0
< 0 (more debt)
________________
 Fiscal Balance

 T-G
< 0 (more debt)
________________
 External Balance:

 X-M
>0
 X-M = (S-I) + (T-G)
The Debt Crisis in Greece and the Eurozone: Is there a Solution?
Financial Balance: Government
21
The Debt Crisis in Greece and the Eurozone: Is there a Solution?
Financial Balance: Government
22
The Debt Crisis in Greece and the Eurozone: Is there a Solution?
Financial Balances: Private Sector balance
The Debt Crisis in Greece and the Eurozone: Is there a Solution?
Financial Balances: Private Sector Delevers
The Debt Crisis in Greece and the Eurozone: Is there a Solution?
Financial Balances: Private and Government Surplus
The Debt Crisis in Greece and the Eurozone: Is there a Solution?
Stability and Growth Pact Fiscal
Private Sector Surplus S>I
Deficit Limit = -3%
Fiscal Surplus =
0%
Fiscal Surplus = 2%
+1.5%
Feasible Range for Country
Fiscal Surplus = 4%
to Repay Debt
Current Account
Deficit
Current Account
Surplus
+1%
-1.5%
+2%
-1%
-2%
Private Sector Deficit S<I
Increasing Fiscal
Surplus
Stability and Growth Pact Fiscal
Deficit Limit = -3%
Private Sector Surplus S>I
Fiscal Surplus =
0%
Fiscal Surplus = 2%
Feasible Range with Export Constraint
Fiscal Surplus = 4%
+1.5%
Current Account
Deficit
Current Account
Surplus
+1%
-1.5%
+2%
-1%
-2%
Private Sector Deficit S<I
Increasing Fiscal
Surplus
b
Fiscal Surplus T>G
II
Ib
Private Sector Deficit S<I
Private Sector Deficit
Private Sector Surplus S>I
Ia
Current Account
Deficit X<M
IIIb
Current Account
Surplus X>M
Private Sector Deficit
Private Sector Surplus
Private Sector Balance =
0
IV
Private Sector Surplus
IIIa
Fiscal Deficit T<G
Fiscal Surplus
Private Sector Surplus = 0%
Private Sector Surplus = 2%
Private Sector Surplus = 4%
Current Account
Deficit
+1%
+2%
Current Account
Surplus
-1%
-2%
Fiscal Deficit
Increasing Private Sector
Surplus
Fiscal Surplus T>G
Private Sector Deficit S<I
Private Sector
Deficit
Private Sector Surplus S>I
Feasible Range to Repay
Debt
Current Account
Deficit X<M
Current Account
Surplus X>M
- 3%
Stability and Growth Deficit Limit
Private Sector Deficit
Private Sector
Financial Balance = 0%
Private Sector Surplus
Private Sector
Surplus
Fiscal Deficit T<G
Fiscal Surplus T>G
Private Sector Deficit S<I
Private Sector
Deficit
Current Account
Deficit X<M
Private Sector Surplus S>I
Current Account
Surplus X>M
Stability and Growth Deficit Limit
- 3%
Private Sector Deficit
Private Sector
Financial Balance = 0%
Private Sector Surplus
Feasible Range with Export Constraint
Private Sector
Surplus
Fiscal Deficit T<G
Fiscal Surplus T>G
Private Sector Deficit S<I
Current Account
Deficit X<M
Private Sector
Deficit
Probable Range for Euro Periphery
Current Account
Surplus X>M
- 3%
Stability and Growth Deficit Limit
Private Sector Deficit
Private Sector
Financial Balance = 0%
Private Sector Surplus S>I
Private Sector Surplus
Private Sector
Surplus
Fiscal Deficit T<G
Thank you
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