Place of Britain in a Future Europe
Martin Wolf, Associate Editor & Chief
Economics Commentator, Financial Times
Oxford Foundation for Law, Justice and
Society
Oxford 5th October 2012
Place of Britain in a future Europe
“The effort to bind states together may lead,
instead, to a huge increase in frictions among
them. If so, the event would meet the
classical definition of tragedy:
hubris (arrogance); ate (folly); nemesis
(destruction).”
Martin Wolf, FT, December 1991.
Place of Britain in a future Europe
Will the eurozone survive the crisis?
• Eurozone crisis:
– Sources of the crisis
– Symptoms of the crisis
– Solutions to the crisis
• UK in a new European Union
4
1. Eurozone crisis: sources
• This is not, in its origin, a fiscal crisis, but a balance of payments
cum financial crisis.
• In the run up to the crisis, there were huge internal capital flows.
These opened up current account imbalances and generated
huge divergences in competitiveness.
• After 2008, cross-border private financial flows suffered a series
of “sudden stops”. These caused, or aggravated, a fiscal crisis.
• The view that this is a fiscal crisis lets creditors blame debtors.
This is bad economics and worse politics.
• The correct view that this is a financial crisis puts blame on both
creditors and debtors. That is good economics and better
politics.
5
1. Eurozone crisis: sources
NOT THE ROAD TO THE EUROZONE CRISES
NET PUBLIC DEBT 2007
(relative to GDP)
120
105
100
87
73
80
60
60
64
50
41
40
22
27
11
20
0
-20
-40
-60
-80
-73
6
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Au
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-100
1. Eurozone crisis: sources
NOT THE ROAD TO THE EUROZONE CRISIS
Source: IMF WEO database April 2012
NET PUBLIC DEBT
(over GDP)
180
160
140
120
100
80
60
40
20
0
Greece
Italy
2007
7
Portugal
2010
2012
Spain
2014
Ireland
1. Eurozone crisis: sources
ROAD TO THE EUROZONE CRISES
CURRENT ACCOUNT BALANCES
(1997-2007 averages, per cent of GDP)
8.0
6.0
4.0
2.0
0.0
-2.0
-4.0
-6.0
-8.0
-10.0
8
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-12.0
1. Eurozone crisis: sources
LOST COMPETITIVENESS
UNIT LABOUR COSTS IN MANUFACTURING
200
180
160
140
120
100
80
60
9
9
0
0
1
1
2
2
3
3
4
4
5
5
6
6
7
7
8
8
9
9
0
0
1
99 99 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 01 01 01
-1 3-1 1-2 3-2 1-2 3-2 1-2 3-2 1-2 3-2 1-2 3-2 1-2 3-2 1-2 3-2 1-2 3-2 1-2 3-2 1-2 3-2 1-2 3-2 1-2
1
Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q
Portugal
9
Italy
Ireland
Greece
Spain
1. Eurozone crisis: sources
FAILURE OF NOMINAL WAGE ADJUSTMENT
Source: Bruegel
10
1. Eurozone crisis: sources
• Why were proponents of the eurozone unaware of
the danger of cross-border financial flows and current
account imbalances?
– They thought these flows were the purpose of the exercise;
– They thought currency risk was the only danger; and
– They thought they had eliminated currency risk.
• They were wrong:
– Currency risk is not the only danger and
– Currency risk cannot be eliminated, so long as the possibility
of secession remains. It will re-emerge as credit risk.
11
1. Eurozone crisis: sources
• Even regions within countries can suffer the
consequences of current account imbalances:
– These will show up as regional recessions;
– But, for regions within countries, mechanisms for handling
the worst consequences of regional “busts” exist:
• Support of the financial system;
• Fiscal transfers; and
• Labour mobility.
– These work adequately.
12
1. Eurozone crisis: sources
• Eurozone member countries do not have such
mechanisms of support.
• They are in a gold-standard type of mechanism: the
adjustment mechanism was depression.
• It never seemed plausible that this could work – or
would be allowed to work.
• As a senior Italian official told me: “we are not
Latvia”.
13
1. Eurozone crisis: sources
• They did have a central bank, which helped. But, as
Spain has discovered, support from the European
Central Bank is not the same as having one’s own
central bank.
• The contrast between Spain and the UK is striking.
They have similar fiscal situations, but totally different
interest rates on public debt.
• The explanation for this divergence between the two
countries is liquidity, currency and default risk.
14
1. Eurozone crisis: sources
WHO’S THE MORE INDEBTED?
NET PUBLIC DEBT IN SPAIN AND THE UK
(as per cent of GDP)
90
80
70
60
50
40
30
20
10
0
1999
2000
2001
2002
2003
2004
Spain
15
2005
2006
2007
United Kingdom
2008
2009
2010
2011
2012
1. Eurozone crisis: sources
WHO’S THE MORE INDEBTED?
YIELDS ON GOVERNMENT BONDS
8
7
6
5
4
3
2
1
0
1/1/08
1/1/09
1/1/10
Spain
16
1/1/11
UK
1/1/12
1. Eurozone crisis: sources
• The conclusion is that high-income countries embedded inside
a currency union are more vulnerable to balance of payments
cum financial crises than countries with floating exchange rates
and their own central banks.
• They are more like emerging countries with exceptionally hard
exchange-rate pegs.
• The idea that eliminating currency crises would eliminate crises
was a gigantic error.
• The currency union replaced the brief currency crises of the
exchange-rate mechanism with long-running solvency,
employment and political crises.
17
1. Eurozone crisis: symptoms
• The symptoms of the crisis include:
– Dwindling cross-border finance, capital flight and bank runs;
– Private retrenchment, collapsing GDP and soaring
unemployment;
– Exorbitant bond yields in deficit countries;
– Tighter links between domestic banks and their
governments;
– Political and economic stress; and
– Rising political friction.
18
19
Portugal
Greece
Ireland
01/07/2012
01/04/2012
01/01/2012
01/10/2011
01/07/2011
01/04/2011
01/01/2011
01/10/2010
01/07/2010
01/04/2010
01/01/2010
01/10/2009
01/07/2009
01/04/2009
01/01/2009
01/10/2008
01/07/2008
01/04/2008
01/01/2008
1. Eurozone crisis: symptoms
ROAD TO THE EUROZONE FISCAL CRISES
SPREADS OVER BUNDS
(percentage points)
50
45
40
35
30
25
20
15
10
5
0
20
France
Italy
Spain
01/07/2012
01/04/2012
01/01/2012
01/10/2011
01/07/2011
01/04/2011
01/01/2011
01/10/2010
01/07/2010
01/04/2010
01/01/2010
01/10/2009
01/07/2009
01/04/2009
01/01/2009
01/10/2008
01/07/2008
01/04/2008
01/01/2008
1. Eurozone crisis: symptoms
ECB INTERVENTION BLIPS
SPREADS OF 10-YEAR GOVERNMENT
BONDS OVER BUNDS
7
6
5
4
3
2
1
0
1. Eurozone crisis: symptoms
THE DEATH OF FINANCIAL INTEGRATION
HOLDINGS OF SPANISH GOVERNMENT BONDS
Bruegel database of sovereign bond holdings developed in Merler and Pisani-Ferry (2012 )
100.0%
90.0%
80.0%
70.0%
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
_1 _2 _3 _4 _1 _2 _3 _4 _1 _2 _3 _4 _1 _2 _3 _4 _1 _2 _3 _4 _1
07 007 007 007 008 008 008 008 009 009 009 009 010 010 010 010 011 011 011 011 012
0
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
Resident Banks
Other Residents
21
Central Bank
Non-Residents
Other Public Institutions
1. Eurozone crisis: symptoms
THE DEATH OF FINANCIAL INTEGRATION
HOLDINGS OF ITALIAN GOVERNMENT DEBT
Bruegel database of sovereign bond holdings developed in Merler and Pisani-Ferry (2012)
100.0%
90.0%
80.0%
70.0%
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
20
07
_
20 1
07
_
20 2
07
_
20 3
07
_
20 4
08
_
20 1
08
_
20 2
08
_
20 3
08
_
20 4
09
_
20 1
09
_
20 2
09
_
20 3
09
_
20 4
10
_
20 1
10
_
20 2
10
_
20 3
10
_
20 4
11
_
20 1
11
_
20 2
11
_
20 3
11
_
20 4
12
_1
0.0%
Resident Banks
22
Central Bank
Other Residents
Non-Residents
1. Eurozone crisis: symptoms
THE PATH TO STAGNATION
23
1. Eurozone crisis: solutions
• How is the eurozone going to resolve its crisis?
• I see two scenarios: the catastrophic and the painful:
– Partial or complete break-up; or
– An extended and painful period of adjustment, via
depression and structural reform.
24
1. Eurozone crisis: solutions
• Here are the challenges to be met if the currency
union is to survive:
1. Debt write-offs: to clear up the legacy costs of the poorly
structured and managed currency union, Mark I.
2. Financing: to prevent financial, fiscal and economic
collapses. By “financing”, I mean an ability to maintain a
working financial system and maintenance of manageable
costs of government funding.
3. Adjustment: structural reforms and divergent inflation across
the eurozone, with higher inflation and stronger final
demand in core countries. This will take at least 5-10 years.
25
1. Eurozone crisis: solutions
•
In the long term, the euro zone needs to be a minimum federal
union
•
This should include:
– A banking union: this would be possible, without fiscal
backup, if (and only if) banks could be resolved without
budgetary support.
– An adequate safety net: Eurobonds are one way to do this;
and a bigger European Stability Mechanism, plus European
Central Bank support, is another. A permanent large-scale
“transfer union” is indeed undesirable.
– A supportive central bank.
•
The fiscal compact cannot be a binding constraint.
26
1. Eurozone crisis: solutions
• Willingness to act was substantial, once it became obvious that
the original design had failed. But willingness to act has also
been insufficient.
• The obstacles to action are of three kinds:
– Economic: it is hard to make this work;
– Ideological: the difference in economic perspectives are large; and
– Political: the countries and peoples do not like one another very
much and do not identify with one another very much.
• Such reforms also raise huge questions about political
legitimacy.
• It will be a bad marriage or a messy divorce.
27
2. Britain in a new Europe
• What does this mean for Britain?
• It means fundamental change in relations with the
rest of the EU, for sure.
• But the nature of the fundamental change depends
on the outcome for the eurozone over which Britain
has little, if any, influence.
• The way I analyse this question is as follows:
– The status quo in the eurozone is untenable;
– Thus, the eurozone will either fragment, so becoming more
homogeneous, or it will become much more integrated.
28
2. Britain in a new Europe
• If the eurozone fragments, it will either survive, in
large part, or disappear altogether;
– If it survives, in part, it might do so in one big block (minus,
say, Greece) or after the exit of creditor nations (led by
Germany) or after the exit of a group of debtor nations;
– If it breaks up, in whole or in part, the EU will be in a legal
limbo, since members are required to be in the eurozone;
– The UK will need to decide on where it would fit into an EU
that would follow a partial or complete break up of the
eurozone.
29
2. Britain in a new Europe
• If the eurozone stays together, it will have to become
a banking union, which will force it to become a fiscal
union, in some part:
– This will require more fiscal and financial discipline and more
fiscal and financial support.
– That would transform Britain’s position, since the questions
that most affect it will increasingly be decided within a new
quasi-federal Eurozone grouping. That is particularly true of
financial regulation.
30
2. Britain in a new Europe
• What would the options for Britain then be?
– Joining the eurozone.
– Staying inside the EU and accepting the outcome of Eurozone
decisions, over which Britain might have little influence.
– Seeking to move into the European Economic Area, while
accepting that it would have no influence on single market
regulation (including on finance).
– This would also put the UK outside the common agricultural policy,
common fisheries policy, co-operation over justice and home
affairs, the common foreign and security policy and full budgetary
demands.
– Moving into EFTA.
– But what would the response of other members be to these
options?
31
2. Britain in a new Europe
• Political implications are worth thinking about:
– We are talking about massive upheavals in relations among
members of the Eurozone and members of the EU;
– One possibility is that if the Eurozone became more federal,
the UK would break up (or at least be more likely to break
up). Similar developments seem likely in other EU members
(Spain?);
– The big point is that the future of the EU would become
wildly unpredictable
32