Some Observations on the Euro Area Crisis
and the Ways Out
“Crisis in the Euro Area, the Economic and Monetary Union,
and the Future of the EU”
The Economic Development Foundation
Conference Hall in Levent, Istanbul.
25th January 2011
Francesco Paolo Mongelli
(ECB and Frankfurt JW Goethe University)
1
Preamble, caveats, and disclaimer
I would like to thank Prof. Dr. Haluk Kabaalioglu of the Yeditepe University in Istanbul, and the
Economic Development Foundation, for inviting me today.
I have been asked to speak about: 1) the causes of the crisis in some member states of the euro area, 2)
how this affects the stability of the euro area as a whole, and 3) whether the measures which are
being undertaken are sufficient to relieve the current situation.
Before I even start addressing these issues, a few caveats and disclaimers are in order:
•
First, I will be speaking under my own responsibility and my views may not necessarily reflect
those of the ECB:
•
Second, I am not sure that I can competently address all these above issues, but I can try to offer
some personal observations; and
•
Third, our understanding of the factors behind the crisis and how they weighted on each country is
still evolving: the remedies are also evolving; and the economic and financial conditions are also
fluid. There are upward potentials but also still downside risks. Moreover, it will take time to see
the results of the policies enacted by each euro area country, and for a new institutional framework
to crystalize.
That’s why I will only offer some observations.
2
My aim today is to…
…. illustrate how the crisis – from which we are gradually emerging -- is the result of
various factors, failings and misjudgements. In fact, the crisis lays at the intersection of
diverse events, developments and choices. Some go back many decades.
Plan of my presentation
Part 1. Features of the European process of integration
Part 2. Why, when and with whom a monetary union?
Part 3. Why EMU? Which benefits to consumers and corporate sector?
Part 4. Twelve years with the euro (1): some achievements and some failings
Part 5. A full-blown systemic financial crisis […and then the sovereign crisis of the
euro area]
Part 6. The remedies
Part 7. Some concluding observations
3
Part 1. Features of the European Process of Integration
• The European path to economic and monetary union is unique in history, as it
has been based principally on the concept of a single market shared by
sovereign countries. Various institutions allowed the EU to work.
• This is quite different from most monetary unions in the past, in which the prior
creation of a political union - a nation state - paved the way for economic and
monetary integration.
• The following two pictures show that in the EU/euro area we are dealing with a
functional process of integration that started with the founding of the European
Coal and Steel Community (ECSC) in 1952 and was then followed up with the
establishment of the European Economic Community with the Treaty of Rome
in 1957.
4
Political Integration starting point
POLITICAL INTEGRATION
ECONOMIC INTEGRATION
MONETARY INTEGRATION
Economic and Monetary
Integration
POLITICAL INTEGRATION
ECONOMIC INTEGRATION
Economic Integration starting point
MONETARY INTEGRATION
Economic Integration, then exerts pressure
towards Monetary Integration, and also Political
Integration
5
The unfolding of European integration (1)
Bela Balassa (1961) suggested an index of institutional integration based on five main stages:
– In Stage 1 the EU 6 formed a Free Trade Area (FTA): i.e., an area where tariffs and quotas
are abolished for imports from area members, which, however, retain national tariffs and
quotas against third countries;
– In Stage 2 the EU 6 formed a Customs Union (CU): i.e., a free trade area setting up
common tariffs and quotas (if any) for trade with non-members (since 1968);
– In Stage 3 the EU 6 formed a Common Market (CM): i.e., they abolished non-tariff
barriers to trade (promoting the integration of product and service markets) as well as
restrictions on factor movement (promoting the integration of capital and labour markets);
– In Stage 4 the EU 6 formed an Economic Union (EUN): i.e., a common market with a
significant degree of co-ordination of national economic policies and/or harmonisation of
relevant domestic laws; and
– In Stage 5 the EU 6 pursued Total Economic Integration (TEI) : i.e., an economic union
with all relevant economic policies conducted at the supranational level (like the single
monetary policy).
We proposed an index built by assigning “scores” to the level of integration recorded for each stage.
6
An Index of Institutional Integration for the EU-6
100
Monetary Union (1999)
90
Common Market (1993)
80
70
EMS (1979)
Customs Union (1968)
Overall Index of Integration
60
50
40
Monetary Union (1999)
Overall Index of Integration
CAP (1962)
30
20
Sub-Index of Monetary and Financial Integration
Currency Convertibility
10
Notes and Coins
Capital Market Liberalization
EMS (1979)
0
58 960
19
1
62 964
19
1
66
19
68
19
70
19
72 974
19
1
76
19
78 980
19
1
82 984
19
1
86
19
88
19
90 992
19
1
94
19
96
19
98
19
00 002
20
2
04 006 008
2
20
2
7
• The European path to integration has advanced for so long because it proved overall highly beneficial.
• Unknown perhaps to most founders of the EEC in 1957, many decades later an entirely new path
towards economic and monetary union (EMU) surfaced
• But how could policy makers tell if a group of countries was ready? What were the reasons to pursue
monetary integration? Moreover, given that EMU would not have relied on a full political union, which
other conditions mattered?
• So the crucial issues became: why, when and with whom a monetary union? Plans had to be drawn,
arrangements had to be made, and countries had to prepare along the following stages.
STAGE THREE- 1 Jan ‘99
STAGE TWO- 1 Jan ‘94
STAGE ONE - 1 Jul ‘90
Complete freedom for capital
transactions
Increased co-operation
Free use of the ECU
(European Currency Unit,
forerunner of the €)
Improvement of economic
convergence
Establishment of the
European Monetary Institute
(EMI)
Ban on the granting of central
bank credit to the public
sector
Increased co-ordination
of monetary policies
Strengthening of economic
convergence
Start of preparatory work for
Stage Three
National central banks
become fully independent
with price stability as their
primary objective
Maastricht Treaty gets
binding (on 7 Feb 92)
Preparatory work for
Stage Three
Irrevocable fixing of
conversion rates
Introduction of the euro in 11
EU Member States
Foundation of the Eurosystem
and transfer of responsibility
for the single monetary policy
to the ECB
Entry into effect of the
intra-EU exchange rate
mechanism (ERM II)
Entry into force of the
Stability and Growth Pact
8
Part 2. Why, when and with whom a monetary union?
A conceptual framework used to address these questions is the Optimum Currency Area (OCA) theory.
An OCA is an optimal geographical area for sharing a single currency. Optimality is defined in terms of
various properties reducing the usefulness of nominal exchange rate adjustments:
a. high price and wage flexibility within each country;
b. similar inflation rates in the medium-term;
b. high mobility of factors of production;
c. a high degree of economic openness;
d. high financial market integration;
e. significant diversification in production and consumption;
f. fiscal integration;
g. shared political will; and
h. overall correlation of incomes and similarity of shocks.
The founders of EMU placed strong emphasis on the achievement of price stability and a high degree of
(nominal) economic convergence prior to the start of a currency union.
9
OCA theory: has weaknesses and limitations…
•
Several OCA properties are difficult to measure… and evaluate against each other
•
“Problem of inconclusiveness” and also a “problem of inconsistency”
•
Difficult to find clear normative implications: no simple “OCA-test”
•
1960s-mid 1970s: weakening of analytical framework, and others.
…but we also saw a reassessment of monetary unions
•
the lessons learned from 20 years with the European Monetary System. Keeping separate currencies
(DM, Francs and Liras) while pegging their exchange rates was subject to periodic tensions. A “corner
solution” could solve this dilemma. Also a defensive intent: to safeguard the EU Single Market.
•
advancements in economic theory. Long-run ineffectiveness of monetary policy and no “fine-tuning”.
Gaining low inflation credibility by ‘tying hands’ and establishing a monetary union with a firm
“nominal anchor” country.
•
Advancements in econometrics permitted to “operationalise” some OCA properties: e.g., studies on
similarities of shocks and their transmission, plus comparisons of monetary transmission mechanisms
•
Overall reassessment: association to a currency union is now deemed to generate fewer costs in terms
of the loss of direct control over monetary policy and the exchange rate. There is also more emphasis
on the benefits.
Thus, the balance of judgements shifted in favour of monetary unions  Fewer costs (in terms
of the loss of direct control over policy tools), and more emphasis was cast on diverse
micro and macro benefits.
10
Part 3. Why EMU? Which benefits to consumers and corporate sector?
Looking forward: “endogeneity of OCA”
The OCA theory was jolted by Rose and Frankel who showed that monetary unions lead to a significant
deepening of reciprocal trade.
• The implications for the forthcoming euro area were substantial. EMU may turn into an OCA after the
launch of the euro even if it was not an OCA before. “…countries which join EMU, no matter what
their motivation may be, may satisfy OCA properties ex post even if they do not ex ante!”
•
The perspective on the “why, when and with whom?” thus changed!
•
The endogeneity emerges from a removal of a “barrier” like national monies.
• Trading and information costs are reduced  enhancing price transparency  discouraging price
discrimination, thus, and reducing market segmentation and fostering competition.
• A single currency is seen as “a much more serious and durable commitment”  it precludes future
competitive devaluations
•
Facilitates foreign direct investment within the monetary union and the building of long-term
relationships.
The “endogeneity of OCA”may have weakened some residual resistances.
Is there a way to represent these developments? A useful diagramme
Yes, by referring to the optimum currency area (OCA) theory. At its most basic level, the
OCA theory is about openness, flexibility and correlation. Members of an OCA need to be:
• ‘Open’ vis-à-vis each other in terms of trade and financial integration. This reduces the
usefulness of national exchange rates, spurs competition, improves the allocation of
resources across the area and fosters growth.
• ‘Flexible’ in terms of price and wage flexibility, but also the mobility of capital and labour
(both occupational and geographical). Flexibility enhances efficiency and also facilitates
the adjustment following a shock.
• ‘Highly correlated’ with each other. This implies the absence of persistent and
irremediable divergence over the medium to long term. Correlation is promoted by low and
similar inflation rates, highly diversified production and consumption diluting the possible
impact of country-specific shocks, broad similarity of policy preferences. Financial
integration helps smoothing asymmetric shocks and spurs correlation as does fiscal
discipline.
12
Dynamics set in motion by monetary unions
When the “Endogeneity” of OCA Dominates
Advantages of common
currency dominate
Correlation of
incomes
3
OCA line
Advantages of common
currency dominate
2
EMU
1
EU
OCA line
Higher Flexibility
Extent of trade among members
of group (Openness)
13
Why MUs? Which benefits to consumers and corporate sector?
A
Benefits from price stability.
B
Catalyzing economic integration and lowering cost of capital.
C
Increasing risk-sharing.
D
Raising efficiency.
E
Lowering costs of conducting international transactions.
F
Enhancing transparency and fostering competition.
G
Support in the strengthening of adjustment mechanisms.
14
Part 4. Twelve years with the euro (1): some
achievements, but…
Price stability has been broadly achieved
• During 1999-2010 average CPI inflation has been
about 1.97 percent.
• In almost every single member country inflation
has never been as low as during these twelve years
with the euro. Inflation expectations remained
well anchored.
Growth
• Average real GDP growth was slightly higher in
the euro area during 1999-2008 than in the
15
previous decade. Real GDP per capita fared better.
Part 4. Twelve years with the euro (2): ..there were
failings
Despite several benign outcomes, we saw diverse
failings that allowed various fault lines to build up
over long periods namely:
• weak public finances in a group of countries,
• persistent imbalances in another overlapping group
and
• slow productivity growth in some others.
The global financial crisis, whose epicentre seemed
initially far away, has exposed and exacerbated these
fault lines.
16
What happened?
• Gradual build-up of current account imbalances originating from a domestic credit boom in some
countries.
• Financial market-driven ‘exuberance’ fuelled a boom in real estate activities.
• At the same time, diverse manufacturing activities shrank, and jobs were lost.
• After the real estate bubble burst and the global financial crisis hit, fiscal policies became
unsustainable.
How could these fault lines build-up for so long? There were weak deterrents.
• Multilateral surveillance failed. Various EU/euro area institutions did not have enough teeth to fully
enforce the Stability and Growth Pact and push for and enforce more changes at national levels  in
November 2003, the SGP was even weakened.
• Financial market discipline was largely absent until well into the crisis  1st decade financial market
participants and rating agencies did not discriminate between national issuers with different standings.
No deterrant against excessive deficits and/or sustained high public indebtedness (that were however
apparent). But, when the assessment changed about sovereign solvency, spreads soared as did premia
on credit default swaps (CDSs).
17
Part 5. A full-blown systemic financial crisis…
…. after Lehman Brothers bankruptcy in September 2008 money markets seized up.
• Unprecedented in size, if measured by financial losses and fiscal costs,
• Unprecedented in extent, if measured by its geographical reach, and
• Unprecedented in speed and synchronisation, if measured by the precipitous fall in
worldwide economic output.
• International trade plummeted, which affected euro-area economies disproportionately
due to their high degree of openness.
• The construction sector in many countries came to a standstill and unemployment
climbed to levels not seen for decades.
• Budget deficits soared in all euro-area countries due to a drop in many sources of
revenues, the expense of shoring up the economy, and the cost of various types of support
to financial institutions.
18
19
An observation: achievements and failings are interconnected…
…but there was also an institutional vacuum
• When the Greek sovereign crisis intensified in late 2009 and early 2010, the disruptive
potential of financial market backlash and threats of rapid contagion had not been fully
grasped.
• Dysfunctional policy debate disaffection rose
• The governance of EMU was designed without a framework to deal with a sovereign crisis
in the euro area.
• Why? As a deterrent to underpin the no-bailout rule, there was no facility for crisis
management and resolution: but we found out the hard way that this deterrent didn’t work.
• Instead, a Medium-Term Financial Assistance facility is being used by diverse non-euro
area EU countries. The current policy debate is mostly about how to fill this vacuum.
20
GBP
4
EUR
USD
Sep. 2008:
Intensification of
crisis
3.5
Spring
2010:
Sovereign
debt crisis
3
Aug. 2007:
Origin of crisis
2.5
Dec.
2009:
Initiation
of
phasingout
2
1.5
1
0.5
0
Jan-07
Jul-07
Jan-08
Jul-08
Jan-09
Jul-09
Note: Spreads are the difference between 12-month Euribor/Libor and Overnight Index Swap rates in basis points
Source: Bloomberg and ECB calculations
Latest observation: 08 December 2010
Jan-10
Jul-10
21
Phase IV - Renditeabstände 10-jähriger Staatsanleihen ausgewählter Länder gegenüber dt.
Bundesanleihen
Beginning of the financial
turbulence
Start of the global
financial and economic
crisis
1000
9 Aug 2007
Initiation of the temporary
phasing out
15 Sep 2008
3 Dec 2009
Start of the sovereign
debt crisis
7 May 2010
900
800
700
600
500
400
300
200
100
0
Jan-07
Apr-07
Jul-07
Oct-07
Jan-08
Greece
Apr-08
Jul-08
Portugal
Oct-08
Jan-09
Spain
Apr-09
Jul-09
Italy
Oct-09
Jan-10
Apr-10
Jul-10
Oct-10
Jan-11
Ireland
22
Part 6. Some remedies
The EU, and the euro area in particular, have responded to the crisis with various policy
measures and arrangements, some of which are still being negotiated, including:
a. Financial consolidation accompanied by structural reform:
• All EU countries are reducing their budget deficits albeit at different paces as needed.
• This is being accompanied by structural reforms to improve growth and growth potential
and support long-term fiscal sustainability  implementation of the Europe 2020 strategy
and National Reforms Programmes
b. Financial stabilisation: we now have the European Financial Stabilisation Mechanism
(EFSM) and the European Financial Stability Facility (EFSF). In 2013 they will be replaced
by a permanent European Stability Mechanism (ESM) that will lend but under strict
conditionality.
c. Financial repair: The EU’s regulatory and supervisory framework has significantly
strengthened (see next figure).
23
The new supervisory framework in the EU
Micro-prudential supervision
European System of Financial
Supervision
E SA
European Banking Authority
European Insurance and
Occupational Pensions Authority
European Securities
and Markets Authority
National supervisors
(including supervisory colleges)
Ensure EU-wide technical supervisory standards
Coordination of supervisors (also in crises)
Macro-prudential supervision
European Systemic Risk Board
ECB
National
central banks
European
Supervisory
Authorities (ESA)
European
Commission
National
Supervisors
(non-voting)
President of the
Economic and
Financial
Committee
(non-voting)
 Issue risk warnings and, if necessary,
Macro-prudential recommendations
24
…continued
d. Strengthening of economic governance framework: it will now focus on prevention
and early correction. The EU aims at adopting the legislation by June 2011. Its main
principles are:
• Strengthened fiscal surveillance: There will be a stronger focus on public debt. Also,
national fiscal framework will be required to meet agreed minimum requirements;
• Broadened economic surveillance: A mechanism to identify and redress
macroeconomic imbalances based on economic analysis and economic and financial
indicators will be introduced, and
• Effective enforcement: A wider set of stricter enforcement mechanisms will increase
incentives for compliance with EU rules and recommendations, making surveillance
more effective.
25
…continued
New instrument are being put in place to address possible risks of macroeconomic
imbalances.
A three-steps procedure is now envisaged:
Step 1. The set up of an alert mechanism based on a number of indicators,
complemented with qualitative analysis.
Step 2. If needed a further in-depth study will be conducted into the root
causes (and potential dangers) from the imbalances.
Step 3. If policy distortions are identified, the country will be asked to take
appropriate measures.
26
Part 7. Some final observations
• Sharing the euro has steadily transformed euro area economies that are now deeply interconnected.
This is generating largely benign effects that represent the intrinsic value of the euro area: it is a
shared asset.
• Yet, such integration has provided the ground for the transmission of the sovereign crisis: through
financial exposures, trade linkages and cross-country asset ownerships.
• While we had long understood the welfare costs of deferring structural reforms for too long, we now
know that in a monetary union this may pose substantial risks to fiscal but also financial stability.
• Euro area countries need to more closely interpret domestic price development, relative costs of
production and unit labour costs, export market shares, and productivity developments.
• This is reminiscent of the pegging of the nominal exchange rate of the past: it entails pegging real
exchange rates.
• We note that the governance of the euro area has already turned around: yet this will take some time
to ascertain.
• Deep at hearth there might still be a need for more clearly explaining what EMU can and cannot do,
and conveying the rationale for its unique governance.
27
Extra slides if needed
28
Bibliography:
• “The Transformational Impact of EMU and the Global Financial Crisis”
• http://www.ceps.eu/book/transformational-impact-emu-and-global-financial-crisis
• “On the benefits and costs of a monetary union”
• http://www.cepr.org/pubs/PolicyInsights/PolicyInsight46.pdf
• “Some observations on 'political' in EMU”
•
http://www.cepr.org/pubs/PolicyInsights/PolicyInsight47.pdf
29
…. with Catching Up by Spain, Portugal and Greece
100
90
80
70
60
50
40
30
20
10
0
50
19
52
19
54 956
19
1
58
19
60
19
62
19
64
19
66
19
68
19
70
19
72
19
74
19
76
19
78
19
80
19
82
19
84
19
EU-9
86
19
88
19
90
19
Spain
92
19
94
19
96
19
Portugal
98
19
00
20
02
20
Greece
30
3.0
2.5
2.0
1.5
1.0
0.5
0.0
2004
5-year BEIR
5-year forward 5 years ahead BEIR
1-year forward 4 years ahead BEIR
6 to 10 years ahead Consensus inflation forecast
Long-term inflation expectations from SPF
2005
Note: Market rates are seasonally adjusted.
Sources: Reuters, ECB, Consensus
Latest observation: December 2010
2006
2007
2008
2009
2010
2011
31
Other factors explaining the sharp trade contraction
The contraction of trade flows is particularly severe
in a “twin crisis”
Global downturn
Financial crisis
Trade elasticity higher during global
downturns (4.7)
Additional downward pressure on
imports in affected countries
•
Precipitous drop in demand, exacerbated by confidence shock
•
Firms’ de-stocking
•
Structure of demand shock: tilted towards traded goods
•
Financial constraints (“financing of trade” vs. trade finance)
•
Disruptions to international supply chains
•
(Quasi-)Protectionism
•
[Freund (2009), Iacovone & Zavacka (2009)]
32