Is the Eurocrisisover? Paul De Grauwe London School of Economics

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1 Is the Eurocrisisover? Paul De Grauwe London School of Economics

2 Outline of presentation Legacy of the sovereign debt crisis Design failures of Eurozone Redesigning the Eurozone Towards a political union?

3 Eurozone split into creditor and debtor nations Figure 5: Cumulated current accounts Belgium Germany Ireland Greece Spain France Italy Netherlands Austria Portugal Finland percent GDP

4 Creditor nations have imposed their rule: Thou shall repay thy debt In order to achieve this, austerity rule is imposed This has created asymmetricadjustment mechanism where most of the adjustment has been borne by the debtor nations Without compensating stimulus by the creditor nations Result: deflationary bias (to which I will return)

5 Relative unit labour costs Eurozone: debtor nations Axis Title Italy Ireland Spain Portugal Greece

6 Relative unit labour costs Eurozone: creditor nations Finland Axis Title Belgium Netherlands France Austria Germany

7 Most striking feature of this legacy: o intense austerity programs triggered since 2010 o do not appear to have increased the capacity of the governments of the debtor countries to continue to service their debt o On the contrary

8 Figure 4: Gross government debt to GDP ratio percent GDP Ireland Greece Spain Italy Portugal

9 Figure 2: Change government debt/gdp ratio (%) and Austerity (% GDP) during change debt ratio y = 3,9125x + 5,6465 R² = 0, Austerity The more intense austerity programs coincide with increasing government debt ratios. The underlying mechanism is well known since the days of Irvin Fisher (Fisher(1936)).

10 Growth of GDP Figure 3: Cumulative GDP Growth and Austerity during y = -1,3889x + 6,4349 R² = 0, Austerity the stronger is the austerity program the deeper is the decline in GDP. The estimated equation suggests that on average for every one percent increase in austerity output declines by 1.4%

11 TINA Is austerity not a necessary price to pay in order to redress the disequilibria in the Eurozone? Issue is not whether the periphery had to engage in austerity or not. They had to (although they should have been allowed more time). The issue is whether for the Eurozone as a whole a more symmetric adjustment may not have improved the unfavourabletradeoff between budget balance and economic growth in the periphery. For every reckless debtor there is a reckless creditor

12 Objection: all this is temporary Many economists argue that these effects are temporary When the economy picks up again countries will get out of their predicament. Be patient How patient does one have to be?

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14 The eurocrisisis not over It has led to a legacy of unsustainable debt levels This can only be resolved by a willingness of creditor nations to accept debt restructuring Without this debtor countries face decades of further austerity that will destroy the social and political fabric. In addition the challenge remains to correct the design failures of the Eurozone

15 Eurozone s design failures: in a nutshell 1. Dynamics of booms and busts are endemic in capitalism o o continued to work at national level and monetary union in no way disciplined these into a union-wide dynamics. On the contrary the monetary union probably exacerbated these national booms and busts. 2. Stabilizers that existed at national level were stripped away from the member-states without being transposed at the monetary union level. o This left the member states naked and fragile, unable to deal with the coming disturbances. Let me expand on these points.

16 Design failure I Booms and bust dynamics: national In Eurozone money is fully centralized All the rest of macroeconomic policies is organized at national level Thus booms and busts are not constrained by the fact that a monetary union exists. As a result, these booms and busts originate at the national level, not at the Eurozone level, and can have a life of their own for quite some time. At some point though when the boom turns into a bust, the implications for the rest of the union become acute

17 Monetary union can exacerbate national booms and busts In fact the existence of the monetary union can exacerbate booms and busts at the national level. This has to do with the existence of only one policy interest rate when underlying macroeconomic conditions are very different. The fact that only one interest rate exists for the union exacerbates these differences, o i.e. it leads to a stronger boom in the booming countries and o a stronger recession in the recession countries than if there had been no monetary union.

18 Design failure II: no stabilizers left in place Lender of last resort existed in each member country at national level. Absence of lender of last resort in government bond market in Eurozone exposed fragility of government bond market in a monetary union

19 Fragility of government bond market in monetary union Governments of member states cannot guarantee to bond holders that cash would always be there to pay them out at maturity Reason: they issue bonds in a currency over which they have no control; euro is like a foreign currency Contrast with stand-alone countries (i.e. countries that issue their own money) that give this implicit guarantee o because they can and will force central bank to provide liquidity o There is no limit to money creating capacity

20 Self-fulfilling crises This lack of guarantee can trigger liquidity crises o Distrust leads to bond sales o Interest rate increases o Liquidity is withdrawn from national markets o Government unable to rollover debt o Is forced to introduce immediate and intense austerity o Automatic stabilizers are switched off o Producing deep recession and Debt/GDP ratio increases This leads to default crisis Countries are pushed into bad equilibrium Which leads to crises of the sovereign and the banks

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22 Summary The Eurozone was left unprepared to deal with endemic booms and busts in capitalism o Probably these were even enhanced because of the existence of the monetary union While nothing was in place to stabilize an unstable system that pushed some countries into bad equilibria and others in good equilibria In fact some of the pre-existing stabilizing forces were switched off All this led to a situation in which national governments were weakened vis-à-vis financial markets. The latter rule supreme in Eurozone

23 Redesigning the Eurozone Role of ECB Coordination of macroeconomic policies in the Eurozone From bureaucratic towards political integration

24 The common central bank as lender of last resort Liquidity crises are avoided in stand-alone countries that issue debt in their own currencies mainly because central bank will provide all the necessary liquidity to sovereign. This outcome can also be achieved in a monetary union if the common central bank is willing to buy the different sovereigns debt in times of crisis. In doing this central bank prevents panic from triggering a self-fulfilling liquidity crisis that can degenerate into solvency crisis And pushing countries into bad equilibria

25 ECB has acted in 2012 On September 6, ECB announced it will buy unlimited amounts of government bonds. Program is called Outright Monetary Transactions (OMT) In defending OMT, Mr Draghi argued that you have large parts of the euro area in a bad equilibrium in which you may have self-fulfilling expectations that feed on themselves.. So, there is a case for intervening... to break these expectations, which... do not concern only the specific countries, but the euro area as a whole. And this would justify the intervention of the central bank

26 ECB acted in 2012 with OMT-program Figure 7: Spreads 10-year government bond rates eurozone Greece Portugal 20 Spain 15 Italy Ireland 10 Belgium 5 France Austria 0 Netherlands Finland percent 1/1/08 4/1/08 7/1/08 10/1/08 1/1/09 4/1/09 7/1/09 10/1/09 1/1/10 4/1/10 7/1/10 10/1/10 1/1/11 4/1/11 7/1/11 10/1/11 1/1/12 4/1/12 7/1/12 10/1/12 1/1/13 4/1/13 7/1/13

27 This was the right step: the ECB saved the Eurozone Note also that while necessary, OMT is insufficient ECB is like fire brigade: it is necessary but not sufficient in the fight against fires.

28 Role ECB is put into question again German Constitutional Court has declared OMT to be illegal and urges ECJ to impose restrictions on OMT, i.e. its unlimited support Only under those conditions is it willing to accept legality If accepted OMT would be ineffective and risk of new self-fulfilling crises would emerge again

29 Arguments of German Constitutional Court Spreads reflect underlying economic fundamentals. Attempts by ECB to reduce spreads are attempts to counter the view of market participants. ECB is in fact pursuing economic policy, which is outside its mandate. Implicit in this argument is assumption of market efficiency o spreads observed from 2010 to the middle of 2012 were the result of deteriorating fundamentals o Thus, the market was just a messenger of bad news. Implication of efficient market theory is that the only way these spreads can go down is by improving the fundamentals, mainly by austerity programs With its OMT program the ECB is in fact reducing the need to improve these fundamentals.

30 I have argued that markets are sometimes gripped by panic. These movements can drive the spreads away from underlying fundamentals, o very much like in the stock markets prices can be gripped by a bubble pushing them far away from underlying fundamentals. In absence of central bank this can lead to sudden stop (liquidity crisis) Countries can be pushed in bad equilibirum Role of central bank is to avoid this outcome

31 Testing two theories of the spreads econometric model of the spreads Spread is explained by a number of fundamental variables o Debt to GDP ratio o External debt o Growth rate of GDP o Competitiveness Then a market sentiment variable is added

32 Debt to GDP ratio and growth rate of GDP have significant effect Quantitative effect is overwhelmed by sentiment variable

33

34 Results suggest that since 2010 markets were first gripped by negative sentiments and tended to exaggerate the default risks of individual countries, i.e. they pushed the spreads way above the fundamental risks. Since the announcement of OMT the reverse has happened. The spreads went down spectacularly mostly driven by positive market sentiments unrelated to the improvements (if any) in the fundamentals.

35 Pain in Spain

36 Figure 12: Government Debt to GDP ratio in Spain and UK percent GDP Spain UK

37 Figure 14: Nominal growth GDP in UK and Spain 6% 5% 4% 3% 2% 1% 0% UK Spain -1% -2% -3% -4% -5%

38 Figure 15: Nominal interest rate - nominal growth rate 6% 5% 4% 3% 2% 1% UK Spain 0% -1% -2% -3%

39 Figure 16: Change in cyclically adjusted primary balance during (percent GDP) Spain UK

40 Governance issue of OMT The European Central Bank s power has increased significantly as a result of the sovereign debt crisis. With the announcement of the OMT program it has become clear that the ECB is the ultimate guarantor of the sovereign debt in the Eurozone. In this sense the ECB has become a central bank like the Federal Reserve and the Bank of England. There is one important difference though.

41 Who prevails? In the US and the UK: primacy of the government over the central bank, o i.e. in times of crisis it is the government that will force the central bank to provide liquidity. This is not the case in the Eurozone: governments depend on the goodwill of the ECB to provide liquidity. o Governments have no power over the ECB and cannot force that institution, even in times of crisis, to provide liquidity. Thus, in the Eurozone today there is a primacy of the central bank over the governments.

42 Democratic legitimacy of OMT The ECB consists of unelected officials, while governments are populated by elected officials. It is inconceivable that these governments will accept to be pushed into insolvency while unelected officials in Frankfurt have the power to prevent this but refuse to use this power. When tested such a model of the governance of the Eurozone will collapse and rightly so.

43 Conundrum The role of the ECB as a lender of last resort is essential to keep the Eurozone afloat. Yet at the same time the present governance of this crucial lender of last resort function is unsustainable o because its use depends on the goodwill of the ECB, othereby making democratically legitimate governments fate depend on the judgment of unelected officials.

44 In order to sustain this role of the central bank as a lender of last resort it has to be made subordinate to the political power of elected officials, o as it is in modern democracies such as the US, Sweden, the UK, etc. This can only be achieved by creating a Eurozone government o that is backed by a European parliament o and that has primacy over the central bank. Until then the Eurozone remains fragile which will reflect itself in volatility in the government bond markets.

45 Coordination of macroeconomic policies Macroeconomic imbalance procedure strengthening the coordination of macroeconomic policies have been adopted and are being put into place. o the monitoring of a number of macroeconomic variables current account balances, competitiveness measures, house prices bank credit o aimed at detecting and redressing national macroeconomic imbalances;

46 However This procedure is being implemented in an asymmetric way Deficit countries experience much more pressure to act, i.e. to reduce spending than surplus countries I have documented this earlier Deflationary bias: everybody tries to achieve surplus which is not possible Let me go into this deflationary bias

47 Deflationary bias since 2011 Slow growth has become endemic in Eurozone Growth GDP in Eurozone (EU18) and EU10 (percent) Eurozone EU Q1 2007Q2 2007Q3 2007Q4 2008Q1 2008Q2 2008Q3 2008Q4 2009Q1 2009Q2 2009Q3 2009Q4 2010Q1 2010Q2 2010Q3 2010Q4 2011Q1 2011Q2 2011Q3 2011Q4 2012Q1 2012Q2 2012Q3 2012Q4 2013Q1 2013Q2 2013Q3 2013Q4 2014Q1 2014Q2

48 What happened since the start of the sovereign debt crisis that has led to a systematic divergence of economic growth in the Eurozone as compared to the non-euro EU-members? The answer lies in the nature of macroeconomic policies pursued in the Eurozone.

49 Two factors played a role Asymmetric adjustment to the external imbalances accumulated during boom years: I have discussed this earlier. It is clear that the asymmetry in the adjustment is an important factor explaining deflationary bias as it pushes all countries including creditor nations to desperate attempts to save more Misdiagnosis about nature of crisis o Supply side versus demand side o Private and public deleveraging

50 Misdiagnosis I: It s a supply side problem Something strange happened: policymakers (especially in the North of Eurozone) identified the problem to be on the supply side and pushed for structural reforms to make supply side more flexible They applied Say s Law: supply creates its own demand (even President Hollande was converted) Supply did not create its own demand

51 Misdiagnosis II: it is a public finance problem The explosion of government debt since the financial crisis was seen as evidence of government profligacy Thus debtor countries were pushed into extreme austerity And creditor nations were told to balance the budget as soon as possible

52 Unfortunately the problem was not on the supply side but on the demand side and the problem was mainly one of excessive debt accumulation of private sector This was a balance sheet recession Leading private agents into desperate attempts at deleveraging That s when o the European policymakers pushed national governments to also deleverage producing the well-known Fisher debt deflation problem o and the same policymakers told national governments to fix their supply side

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54 Quefaire? Stop trying to fix the supply side and fix the demand side Start with public investment Why? It is one of the major victims of ill-advised macroeconomic policies in Eurozone

55 Austerity programs led to strong decline in public investment Figure 8: General government gross fixed capital formation (%GDP) 2,9 2,7 2,5 Axis Title 2,3 2,1 1,9 1,7 1,

56 Leading to less aggregate demand today And less supply in the future Thus, start public investments These can be initiated everywhere, but especially in Germany, a country that can borrow almost for free

57 We have to free ourselves of dogmas One such dogma: balanced budget, i.e. no bond financing of investments o All investments should be financed by current revenue o No well run company follows such a stupid rule Result of this idea is that governments are reducing their responsibility to provide essential public goods (infrastructure, energy investments, environmental investments) This reduces long-term growth of the Eurozone

58 Governance issues of macroeconomic management The European Commission powers to monitor and control budgetary and macroeconomic policies suffers from similar legitimacy issue as the ECB o European Commission can now impose changes in budgetary policies (taxation and spending) o Its power has increased significantly without an increase in accountability Thus Commission can impose taxation and spending cuts without having to bear the political costs of these decisions This goes against basic principles of democracy: no taxation without representation This is unacceptable in democratic societies

59 Bureaucratic versus political integration Increasingly, European integration has taken the form of bureaucratic integration as a substitute for political integration. This process has started as soon as the European political elite became aware that further political integration would be very difficult. This process has become even stronger since the start of the sovereign debt crisis in the Eurozone.

60 Outcome of crisis: the European Commission and the European Central Bank have seen their powers increase significantly, o without any increase in their accountability. These two institutions impose decisions that affect millions of people s welfare, o but the people who are affected by these decisions do not have the democratic means to express their disagreements. As a result, they tend to reject the system as a whole.

61 Output legitimacy Political scientists make a distinction between output and input legitimacy. o Output legitimacy: a particular decision is seen to be legitimate if it leads to an increase in general welfare. o A government that is technocratic can still be legitimate if it is perceived to improve welfare. o Very much influenced by the Platonic view of the perfect State. This is a State that is run by benevolent philosophers who know better than the population what is good for them and act to increase the country s welfare.

62 Input legitimacy Input legitimacy: political decisions, whatever their outcome, must be based on a process that involves the people, through elections that allow the people to sack those who have made bad decisions. However, much of the integration process in Europe has been based on the idea of output legitimacy. The weak part of that kind of legitimacy becomes visible when the population is not convinced that what the philosophers at the top have decided, has improved welfare. That is the situation today in Europe.

63 In many countries there is a perception that the decisions taken in Brussels and Frankfurt have harmed their welfare. It should therefore not be surprising that many people reject the notion of output legitimacy, and instead want input legitimacy, i.e. a procedure by which they can sanction those that have taken harmful decisions. Since they can only do this at the national level, they reject the European level.

64 Towards a fiscal and political union? Only governance that can be sustained in the Eurozone is one where a Eurozone government backed by a European parliament acquires the power to tax and to spend. This will then also be a government that will prevail over the central bank in times of crisis and not the other way around. Put differently, the Eurozone can only be sustained if it is embedded in a fiscal and political union.

65 Fiscal union has two dimensions 1. consolidation of national government debts. o o o o consolidation creates a common fiscal authority that can issue debt in a currency under the control of that authority. This protects the member states from being forced into default by financial markets. This restores the balance of power in favourof the sovereign and against the financial markets Governance structure is created in which the (European) sovereign prevails over the central bank and European bureaucratic institutions rather than the other way around.

66 2. mechanism of automatic transfers o Such a mechanism works as an insurance transferring resources to the country hit by a negative economic shock. o There are limits to such an insurance that arise from moral hazard risk, o But it remains true that such a mechanism is essential for the survival of a monetary union, like it is for the survival of a nation state. o Without a minimum of solidarity (that s what insurance is) no union can survive.

67 All this is well known. It is equally clear that the willingness today to move in the direction of a fiscal union in Europe today is non-existent. This fact will continue to make the Eurozone a fragile institution, the future of which remains in doubt. The euro crisis is not over.

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