The debt crisis in the peripheral countries of the Euro area

Different stories but a same problem: public finances

Greece: dynamic growth before the crisis, but heavy structural problems (tax collection) => structural measures directed towards a market economy Ireland: safe public finances before the crisis, but the burst of the housing bubble translated into heavy losses for banks: a huge cost for public finances => structural measures reshuffling the banking system, partly nationalized Portugal: low growth before the crisis, the consequence of changes in international sectoral specialization => structural measures accelerating changes in the economy Spain: when the housing bubble bursts structural measures towards new engines of growth; rationalization of the banking system

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 Strong tensions on financial markets regarding the debt of peripheral countries

Long-term interest rates Governm ent bonds - 10 years

16 15 14 13 12 11 10 9 8 7 6 5 4 3 J FMAM J J ASOND J FMAM J J ASOND J FMAM J J ASOND J FMAM J J 2008 2009 2010 2011 2.0 J FMAM J J ASOND J FMAM J J ASOND J FMAM J J ASOND J FMAM J J 2008 2009 2010 2011
Coe-Rexecode 104

5.0

4.5 France Germ any Italy Greece Spain Ireland Portugal 4.0

3.5

3.0

2.5

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 Consequences: questions about the future of the Euro area

How can the Euro area survive with such different countries? What kind of economic policies for countries in difficulty? More solidarity or more discipline between member States?

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Contents

1. The convergence process in the Euro area and its consequences on monetary policy 2. The policy mix in the Euro area since 2000 3. How coping with the debt crisis?

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 What are the characteristics of an optimum currency area?

Robert Mundell (1961), gave the basis for a theory of optimum currency areas : A common currency can only be applied in areas or regions with the same economic structure or being able to converge quickly. A same monetary policy can be inappropriate in one country (or a group of countries) in case of differences in terms of economic structure. In this latter case, a possible remedy is a great mobility of production factors Question : What about the Euro area?
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 The level of GDP per capita differs among Euro area countries although there were signs of convergence during the last 15 years
GDP per capita (SPA, Euro area =100)
Euro area (16 countries ) Belgium Germany Ireland Greece Spain France Italy Cyprus Malta Netherlands Aus tria Portugal Slovenia Slovaquia Finland Standard deviation (without Luxembourg) Max/min (without Luxembourg) 1995 100,0 113,2 113,2 90,4 73,7 80,7 101,8 106,1 77,2 75,4 107,9 118,4 67,5 64,9 42,1 94,7 21,9 2,8 2000 100,0 112,5 105,4 117,0 75,0 86,6 102,7 104,5 79,5 75,0 119,6 117,0 72,3 71,4 44,6 104,5 22,1 2,7 2005 100,0 109,1 106,4 130,9 82,7 92,7 100,9 95,5 82,7 70,9 119,1 112,7 71,8 79,1 54,5 103,6 20,6 2,4 2009 100,0 107,4 107,4 118,5 86,1 96,3 100,0 94,4 90,7 72,2 120,4 113,0 73,1 80,6 65,7 102,8 17,1 1,8

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 The poorest countries in 1995 registered the highest economic growth during the last 15 years

GDP per capita growth rate, % 19952009

GDP per capita (1995, Euro area =100)

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 Because of the convergence process, we observed a higher economic growth in the peripheral countries before the crisis (except for Portugal) than the Euro area average
Real GDP growth (annual average, 19952007, %) Real Euro area (16 countries) Germany France Greece Spain Ireland Portugal 2,3 1,6 2,2 3,9 3,7 7,2 2,4

Potential (Eur. Com. Estimates) 2,0 1,5 2,0 3,5 3,3 6,8 2,1

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 , but real convergence also implied higher inflation in high growth countries

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 A similar business cycle, but with higher volatility in some countries

D eviation to trend
5 % 7 6 4 5 4 %

Italy France Germ any Euro area Spain

3 2 1 0

-1 -2 -3

-1

-2

-4 -5 -6

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Ireland Portugal Greece Euro area

99 00 01 02 03 04 05 06 07 08 09 10 11

-4 99 00 01 02 03 04 05 06 07 08 09 10 11

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Coe-Rexecode 144

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 A limited mobility of the labor factor (large discrepancies in unemployment rates)

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 In the U.S. it also exists a discrepancy in GDP per capita even if it seems lower than in the Euro area
Dispersion of GDP per capita in the U.S. and in the Euro area U.S. (2008) Standard deviation of nominal GDP per capita (American States and EA-15)* Standard deviation of nominal GDP per capita (8 U.S. regions and EA-11)** 19,1 Euro area (2009) 29,2

10,5

22,2

* Excluding Columbia district for the U.S. and Luxembourg for the Euro area which are extreme points ** Euro area exluding Luxembourg, Cyprus, Malta, Slovakia and Slovenia
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 A comparison U.S./Euro area

. More mobility of the labor factor in the U.S? Not so sure recently as large discrepancies in the unemployment rate remain Unemployment rate (Feb. 2011): lowest North Dakota 3,7%, U.S. average 8,9%, highest Nevada 13,6%. . Differences in terms of inflation trend seem rather small: March 2011/ March 2011: Northeast urban 2.5%, Midwest urban 2.7%, South urban 2.8%, West urban 2.6%, USA: 2.7%
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To sum up: The Euro area has not all the characteristics of an optimum currency area, although signs of improvement have been noticed before the crisis . Differences in economic structure, although convergence has improved. Strong integration is visible in the high correlation between national business cycles. . Real convergence implies higher real GDP growth, with consequences in terms of higher inflation (this is the major difference with the U.S.). => Real convergence creates a dilemma for monetary policy in a single currency area, especially because not so much mobility in the

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2 if the Euro area is not an optimal currency area, what kind of problems can emerge?
In an economy which is moving towards the technological frontier we can observe the following developments: Productivity Wages =>

GDP per capita

Inflation: tensions in the economy (low unemployment rate or decreasing unemployment rate), Balassa effect (increase in non internationally tradable goods prices, e.g. services as real convergence implies also nominal convergence of price levels) Appreciation of the exchange rate and increase in interest rates BUT this was not possible in the Euro area for converging countries
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=>

=>

 Has monetary policy been appropriate to the economic situation since 2000?
An application of the Taylor rule : ECB Repo = average annual growth of potential output (95-2007) 1 (difference between long term and short term interest rates) + inflation + 0.5 * output gap (real GDP/potential GDP) + 0.5 (inflation rate -2 the ECB target)

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 Between 2000 and 2008, monetary

policy was restrictive for Germany and expansionist for countries which were converging
Interest rates following the Taylor rule
16 %

12

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France Germany Ireland Greece Spain Euro area ECB Repo

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

-8 1999

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 Consequences: monetary policy has

exacerbated internal disequilibrium
Households debt
% disposable income 130

Non financial corporations debt

% value added 260

120

240

110

220 France Germany Spain

200

100 180 90 160 80 140 70

France Germany Spain

120

60

100

50 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

80 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Coe-Rexecode 128

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 External disequilibrium reflected internal disequilibrium (except in Ireland)

Unit labor costs (compared to Euro area average)
125

Trade balance
250

1999=100

Billions of euros (3 months mov. avg. annualised)

120

200

115

150

110 100 105 Ireland Germany Spain Greece Portugal 50

Ireland Germany Spain Greece Portugal

100

95 -50

90

85

-100

80 00 01 02 03 04 05 06 07 08 09 10 11 12

-150 00 01 02 03 04 05 06 07 08 09 10 11 12

Coe-Rexecode 129

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 No compensation (or not enough) through fiscal policy

Public deficit
5

As a percentage of GDP

-5

-10

-15

-20

Spain Greece Portugal Ireland

-25

-30

-35 1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

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 To sum up: monetary policy was

appropriate for the Euro area, but internal divergences were (almost) inevitable
. Monetary policy was appropriate for the Euro area as a whole but not for all individual members . This was not a mistake of the ECB but the consequence of the real convergence process (a political target, supported by various instruments, e.g. structural funds) . To equilibrate the policy mix, fiscal policy should have been more restrictive in peripheral countries and more relaxed in Germany (the opposite was done). But was it politically possible (Spain close - 22 to the equilibrium, Ireland registered a fiscal

3 Whats next?
Is there any exit strategy from the Euro area? NO . There is not a symmetry between entering and leaving the EMU: technically, what would be the value of the private or the public debt for the country leaving the EMU? If there is a strong depreciation of the new currency (50% or more), the increase of the external debt will not be sustainable. . Which value for the new currency? In the short run, a depreciation of the currency increases the competitiveness, but if it is followed by a strong rise in the inflation rate, interest rates would be pushed up: as a consequence GDP might be hit negatively and competitiveness would deteriorate. . Consequences on remaining countries are not clear. It
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An exercise regarding the sustainability of the public debt in the Euro area countries

2011-2012 : Coe-Rexecode outlook (Spain) and European Commission (Portugal, Italy, Greece) Dec 2010 2013-2020 : Assumptions : - Real GDP close to potential growth (revised downward compared to the pre-crisis period; - Euro area inflation close to 2% (a bit higher inflation for peripheral countries) - Apparent interest rates in line with growth of nominal GDP, including a risk premium. - Public receipts increase as nominal GDP - Public expenditures are adjusted to stabilize the debt/GDP ratio in the medium run (when possible) Reminder: If Bp(t)=G(t)-T(t), the primary deficit, with G(t) the public expenditures (excluding payments) and T the public receipts Total fiscal deficit is B(t) = Bp(t) + r(t)D(t-1), where interest payments is the product between the apparent interest rate and the debt level It comes, D(t) = D(t-1) + B(t)= Bp(t)+(1+r(t))D(t-1) And in % of GDP, the debt dynamics can be written: d(t) = bp(t) + (1+r)/(1+g) d(t-1), with r the apparent interest rate and g the nominal GDP growth rate.

 Underlying assumptions of a scenario on the public debt sustainability

Main assumptions (%, annual average 2013-2020)
Spain 2.5 2.5 5,0 4.2 Portugal 2.0 2.5 4.5 3.5 Greece 2.0 2.5 5,0 4.0 Real GDP growth rate GDP deflator growth rate Fiscal receipts growth rate Fiscal expenditures growth rate Apparent interest rate (average level)

Ireland 2.5 2.5 5,0 3.5

4.5

4.8

5.0

5.0

 The stabilization of the debt/GDP ratio is possible, but only in the long run (around 2015)
Outlook of public finances in peripheral Euro area countries (% GDP)
2010
Spain Primary balance Fiscal balance Public debt Portugal Primary balance Fiscal balance Public debt Greece Primary balance Fiscal balance Public debt Ireland

2015

2020
170 %

P u b lic d e b t
140

-7.3 -9.2 60.1

-1.6 -4.7 73.3

-0.1 -3.3 74.1

110

-6.1 -9.1 93.0

-1.3 -4.9 95.4

0.7 -4.0 96.5

80

50

Ire la n d P o rtu g a l G re e c e S p a in

-4.9 -10.5 142.8

-0.1 -7.9 163.9

0.9 -7.0 165.3

20 2000

2005

2010

2015

2020
C oe -R ex e co d e

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 What can be learnt from this numerical exercise?

Debt dynamics (the snowball effect) is clearly heavily dependant on the level of interest rates: what is sustainable with a 5% interest rate is not anymore sustainable with interest rates at 10% (nominal GDP growth has to increase by the same proportion!). In the long run, peripheral countries can stabilize the debt/GDP ratio with a better discipline regarding fiscal policy. A shock therapy is not needed (it can have a counterproductive effect, see Greece in 2010). It is necessary to buy time. This is exactly the target of the future European Stability Mechanism. It can be a triple win process: no cost for other EMU members states (loans, no gift); no losses for banks (different from the default case);