costly
by Assaf Razin December, 2011
The creation of the euro should now be recognized as an experiment that has led to the sovereign debt crisis in several countries, the fragile condition of major European banks, the high levels of unemployment, and the large trade deficits that now exist in most Eurozone countries. Although the European Central Bank managed the euro in a way that achieved a low rate of inflation, other countries both in Europe and elsewhere have also had a decade of low inflation without incurring the costs of a monetary union.
History
The Treaty of Rome launched the Common Market in 1957. The Common Market developed into the European Economic Community in 1967 and the European Union in the Maastricht treaty of 1992, creating not only a larger free trade area but also providing for the mobility of labor and other aspects of an integrated European market for goods and services.
Monetary Union
The political process evolved through the Maastricht Treatys creation of the European Monetary Union and the plans for the single currency which eventually began in 1999
A single currency means: 1. that all of the countries in the monetary union have the same monetary policy and the same basic interest rate, with interest rates differing among borrowers only because of perceived differences in credit risk. 2. A fixed exchange rate within the monetary union and the same exchange rate relative to all other currencies, even when individual countries in the monetary union would benefit from changes in relative values.
When a county has its own monetary policy, it can respond to a decline in demand by lowering interest rates to stimulate economic activity. But the European Central Bank must make monetary policy based on the overall condition of all the countries in the monetary union. This means interest rates that are too high for those countries with rising unemployment and too low in other countries where wages are rising too rapidly.
The shift to a monetary union and the tough anti inflationary policy of the European Central Bank caused interest rates to fall in countries like Spain and Italy where expectations of high inflation had previously kept interest rates high. Households and governments in those countries responded to the low interest rates by increasing their borrowing, with households using the increased debt to finance a surge in home building and house prices while governments borrowed to finance budget deficits that accompanied larger social transfer programs. The result was rapidly rising ratios of public and private debt to GDP in several countries, including Italy, Greece, Spain and Ireland. Despite the increased risk to lenders that this implied, the global capital markets did not respond by raising interest rates on countries with rapidly rising debt levels.
A different market dynamic affected the relation between the commercial banks and the European governments. Since the banks were heavily invested in government bonds, the declining value of those bonds hurt the banks.
During the euro-bubble years there were huge capital flows to peripheral economies, leading to a sharp rise in their costs relative to Germany
Now that the bubble bursts, should the adjustment be rising wages in Germany or falling wages in Spain? The ECB signals that no inflation in Germany will be tolerated. The recipe is for a prolonged slump in the periphery.
Fiscal Federalism
The transfer of economic resources from members with healthy economies to members who suffer economic setback can best be done through fiscal federalismmost of the risk is privately uninsurable. This is a key difference between US and Eurozone. It remains to be seen whether the EU will develop more elaborate institutions for carrying out fiscal transfers among its members.
UK Government Bonds
Suppose that investors fear that the UK government might be defaulting on its debt. They will sell their UK bonds, driving up the interest rate. After selling these bonds these investors would have pounds that they would want to get rid of by selling them in the foreign exchange market. The price of the pound would drop until somebody else would be willing to buy these bonds. UK money stock will remain unchanged.
Investors cannot precipitate liquidity crisis for a non sigle currency area country
Even if the UK government cannot find the funds to roll over its debt it would force the Bank of England to buy up the government securities. Thus, investors cannot precipitate a liquidity crisis in the UK that could force the UK government into default.
Competitiveness within the Eurozone: decade and a half before the crisis
Greece, Ireland, Portugal and Spain lost a lot of competitiveness: Low interest rates led to a surge in domestic demand. And sharp rises in real wages. Productivity growth was not vigorous enough to compensate.
Debt crisis and fixed exchange rate: lessons from Latin America
Argentina is a case in point. In 2001, it ran through a series of governments before triggering the worlds then-biggest default ($100bn; so small compared to Italys 1.9tn bond market).
To restore competitiveness without breaking Argentinas euro-like currency peg, he engineered a synthetic devaluation. Acrossthe-board export subsidies and import duties came straight out of the textbooks, but didnt work. Just as they often do in Europe today, investors saw the countrys debt dynamics still working against it.
Default fears led to higher bond yields, which led to lower growth and smaller government revenues. This made default more likely in a process that soon became self-fulfilling. After three years of recession, much of southern Europe may already on the brinks of default.
Debt Deflation
The more wages and prices fall, the bigger debt burdens become in real terms. If the economy continues to there will be less money to service debts. But the more they lower wages and prices, the harder is the debt overhang burden is to bear. Irving Fisher (80 years ago) notes that the struggle to reduce debts can sometimes increase indebtedness.
3. Inadequate supply of liquidity because national governments in the south have limited capacity to issue and redeem safe assets that can be bought and sold at predictable prices. The ECB is reluctant to be a lender of last resort to national governments.
2. All 17 members of the Eurozone, plus 6 other countries who wish to join the Euro one day, signed in December 2011, an intergovernmental pact that would enforce stricter fiscal discipline. Sanctions will be imposed on countries that fail to stay with limits of budget deficits, inserting balance budget legislations of members, with the European Court in charge.
This plan to increase the banks capital wont work because the banks dont want to dilute current shareholders by seeking either private or public capital. Instead, they are reducing their lending, particularly to borrowers in other countries, causing a further slowdown in European economic activity.
2. The second strategy calls for the European Central Bank to buy the bonds of Italy, Spain and other high debt to keep their interest rates low. The ECB has already been doing that to a limited extent but not enough to stop Greek and Italian rates from reaching unsustainable levels.
3. The third strategy is favored by those who want to use this crisis to advance the development of a political union. They call initially for a transfer union or a fiscal union in which those countries with budget surpluses would transfer funds each year to the countries running budget deficits and trade deficits.
Greece
The Greek budget deficit of 9 percent of GDP is too large to avoid a further outright default on its national debt. With a current debt to GDP ratio of 150 percent and the current value of Greeces GDP falling in nominal euro terms at 4 percent, the debt ratio would rise in the next 12 months to 170 percent of GDP. Rolling over the debt as it comes due and paying higher interest rates on such debt would raise the total debt even more quickly.
Cutting the interest bill in half by a 50 percent default while balancing the rest of the budget would only reduce the deficit very slowly, from 150 percent now to 145 percent after a year, even if no payments to bank depositors and other creditors were required. It is not clear that financial markets will wait while Greece walks along this fiscal tightrope to a sustainable debt ratio well below 100 percent.
Strings attached
But Germany is now prepared to subsidize Greece and other countries to sustain the euro, Greece and others might nevertheless decide to leave if the conditions imposed by Germany are deemed to be too painful to accept.
Ireland Boom
Philip Lane of Trinity College notes: There was a genuine Irish economic miracle, with very rapid output, employment and productivity growth during the 1994-2000 period. Without entry into the eurozone, this might have petered out. But the fall in interest rates increased the risk that a credit-fuelled property bubble would emerge. So, indeed, it did.
Ireland Bust
The ratio of private credit to GDP jumped from around 100 per cent in 2000 to 230 per cent in 2008. Foreign lenders played a huge role in funding this boom: the net foreign liabilities of domestic banks went from 20 per cent of GDP in 2003 to over 70 per cent in early 2008.
The global financial crisis caused an immediate cessation in the capital inflows. In panic-stricken response, the Irish government guaranteed bank debt in September 2008. As the fiscal costs mounted, driven by the slump and the need to rescue the banks, what began as a financial crisis ended up as a crisis in public debt.
The direct costs of recapitalizing the system are set to be around 36 per cent of GDP.For comparison, the cost of the Asian financial crisis to South Korea was 31 per cent of GDP, while the cost of todays crisis to Iceland might be only 13 per cent of GDP. On the last, according to the IMF, general government debt could be 123 per cent of GDP by 2014. A little over a third of this increase in the public debt ratio would then be a direct result of recapitalizing the banks
Spain
These big capital inflows raised demand for Spanish goods and services, leading to substantially higher inflation in Spain than in Germany and other surplus countries. Both countries are on the euro, so the divergence reflects a rise in Spains relative prices.
A Euro breakup?
No country can be forced off the Euro against its will No country would voluntarily abandon it the shock of leaving would outweighs any advantage of life outside
Conclusion
The UK economist Charles Goodhart once described banks as international in life, but national in death. In the case of a single currency union you should make them European in death. Wholesale banking is genuinely cross-border. German and UK banks have crippling exposures to Ireland, French and German banks to Greece, Spanish banks to Portugal. If one peripheral country defaulted, we would see a contagious banking crisis that would overwhelm some governments ability to cope
The Crisis
Incautious lenders lent borrowers the rope with which the latter could hang themselves, be they irresponsible governments (as in Greece) or foolish private entities (as in Ireland and Spain). The result was huge indebtedness.
Costs
Economic stability loss
LL schedule It shows the relationship of the countrys economic stability loss from joining. It slopes downward. Reason: The economic stability loss that arises because a country that joins an exchange rate area gives up its ability to use the exchange rate and monetary policy for the purpose of stabilizing output and employment. It is lower, the higher the degree of economic integration between a country and the fixed exchange rate area that it joins.
The LL Schedule
Economic stability loss
The economic stability loss that arises because a country that joins an exchange rate area gives up its ability to use the exchange rate and monetary policy for the purpose of stabilizing output and employment. It is lower, the higher the degree of economic integration between a country and the fixed exchange rate area that it joins
LL schedule
Economic stability loss for the joining country
Degree of economic integration between the joining country and the exchange rate area
The GG-schedule
Monetary efficiency gain
The joiners saving from avoiding the uncertainty, confusion, and calculation and transaction costs that arise when exchange rates float. It is higher, the higher the degree of economic integration between the joining country and the fixed exchange rate area.
GG schedule
Monetary efficiency gain for the joining country
Degree of economic integration between the joining country and the exchange rate area
GG
LL
Degree of economic integration between the joining country and the exchange rate area