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To the Point
Discussion on the economy, by the Chief Economist                                                                      January 30, 2012


                                                    The full monty: how to build a strong currency
                                                    union while closing democracy gaps
                                                        The institutions for a strong currency union in Europe are still lacking. To be
                                                         effective, the EMU needs fiscal cooperation (or union), supranational bank
                                                         regulation, and a central bank as lender of last resort to banks and sovereigns.
                                                        Euro zone politicians may opt for the less solid β€œtransfer union” approach, using
                                                         rescue funds instead, but then these funds need to be larger and more flexible.
                                                        The EMU is threatened by β€œdemocracy gaps”, which politicians need to address,
                      Cecilia Hermansson                 not least of which how to meet the challenges for young generations.
                   Group Chief Economist
          Economic Research Department              Fundamentals missing for a well-functioning currency union
                        +46-8-5859 7720
        cecilia.hermansson@swedbank.se              When Swedes evaluated whether or not to enter the EMU through the referendum in
                                                    2003, the focus was on economic effectiveness, stabilisation tools, and political
                                                    aspects of membership. Especially, a situation where Sweden experienced an
                                                    asymmetric shock was viewed as a risk, as it would be impossible to use sovereign
                                                    monetary policy to correct, e.g., an unfavourable cost structure. In addition, the
                                                    mobility of production factors, such as labour, within the union, was considered
                                                    insufficient. This was subject of much debate, as labour market mobility was part of
                                                    Professor Mundell’s optimum currency area (OCA) theories.
                                                    There were also those, e.g. Professor Assar Lindbeck, who argued that the EMU did
                                                    not have effective ways of transferring resources between countries. The focus of the
                                                    2003 referendum, however, was not on the deficiencies of the EMU, but on Sweden’s
                                                    prerequisites to become a member, not least since Sweden had just recovered from a
                                                    deep financial crisis at the beginning of the 1990s and was not yet confident it knew
                                                    how to pursue effective economic policy – which is certainly no longer the case!
                                                    There should have been more focus whether the fundamentals for a well-functioning
                                                    currency union would be in place. According to Professor Barry Eichengreen, the
                                                    prerequisites for a currency union are strong fiscal cooperation or a fiscal union, one
                                                    bank regulator/supervisor (not 17) and a central bank that is without doubt a lender of
                                                    last resort (with regard to both banks and countries).
                                                    The Brussels-based think tank, Bruegel, discusses the euro crisis and the β€œimpossible
                                                    trilemma” of no shared responsibility for public debt, bank sovereign independence
                                                    and a strict prohibition of monetary financing. Its director, Professor Jean Pissay-
                                                    Ferry, argues that the euro zone faces this new trilemma (inspired by Mundell’s
                                                    famous trilemma of free capital flows, stable exchange rates and independent
                                                    monetary policy). He builds on Eichengreen’s argument, and finds that the EMU does
                                                    not have the fundamentals in place, in any of the three areas.
                                                    The Stability and Growth Pact (SGP) was not followed by the members, not even by
                                                    Germany. The no-bail-out clause (Article 125 of the EU Treaty) was at the forefront
                                                    of EMU policy, until the debt crises in periphery countries made it impossible to stick
                                                    to the Treaty. Without changing the Treaty, rescue funds, (the EFSF) have been set up
                                                    and, de facto, the EMU has turned into a transfer union despite the intention to avoid
                                                    this outcome. Monetary financing is not allowed by the Treaty (Article 123), but there
                            No. 1                   have been ways to circumvent this rule, e.g., through ECB lending to banks at
                       2012 01 30                   favourable terms to facilitate their purchases of sovereign debt bonds. Bank regulation
                                                    and supervision are still national. Pan-European stress tests have been given, but there
                                                    is no supranational bank regulator, which means that national interests take over, at
                                                    the expense of transparency and effective crisis management.
To the Point (continued)
January 30, 2012


                                                                                                                                     Democratic shortages must be taken seriously
Chart 1: EMU:s trilemma
                                                                                                                                     All three of these institutions must be in place to make the EMU work (the
                                                                                                                                     β€œfull monty”), but politicians have different views on which of the three they
                                                                                                                                     would like to focus on. France, in particular, would like to start by giving more
                                                                                                                                     responsibility to the ECB as lender of last resort, while Germany has a stronger
                                                                                                                                     focus on using the fiscal compact to set fiscal discipline (even if a full-fledged
                                                                                                                                     fiscal union is probably not preferred by anyone).
                                                                                                                                     The problem with allowing more support through the ECB, without creating
                                                                                                                                     sufficient fiscal discipline, is moral hazard and poorly working incentives. The
                                                                                                                                     problem with focusing only on fiscal discipline is that the current crisis will
                                                                                                                                     not be handled, and a systemic bank crisis evolves and confidence falls.
                                                                                                                                     Instead, transfers are made through the rescue funds – types of support that
                                                                                                                                     would probably not be needed if the three fundamentals were in place.
                                                                                                                                     It seems as if politicians and voters alike are not ready for either a fiscal union,
Source: Bruegel                                                                                                                      or a β€œfinancial union” and thus the ECB:s role would continue to be limited, at
                                                                                                                                     least in theory. Then, the solution with rescue funds would prevail, but, in
                                                                                                                                     order to strengthen confidence so that the expectations of a break-up of the
                                                                                                                                     EMU can recede, the size and flexibility of these funds must be increased.
                                                                                                                                     Politicians are focusing on taxing financial transactions and creating a fiscal
Chart 2: Unemployment rates in euro zone                                                                                             compact. The first idea picks up on voters’ anger with banks and will not help
          25,0
                                                                                                                                     to solve the crisis; there is rather a risk that the financial sector will lose out in
          22,5                                                                                                                       Europe, and that would be negative for economic growth. The second idea is
          20,0                                                                                                                       necessary to create confidence for other support, e.g. from the ECB and IMF,
          17,5
                                                                                                                                     and would perhaps be a first step towards stronger fiscal coordination. Creating
                                                Spain
                                                                                         Greece                                      such a compact, however, is not sufficient for managing the current crisis, as it
Percent




          15,0
                                                                                                                                     would have to be coupled with sizable support through the rescue funds.
          12,5
                                                                                                            Euroland
          10,0                                                                                                                       Even if symmetric growth is not the most important for a currency union –
                                                                                                                   US
           7,5                                                                                            Germany
                                                                                                                                     Wyoming and Texas do have different economic structures and growth
                                                                                                                                     developments – it is not possible to build a well functioning EMU and EU
           5,0
                                                                   Japan                                                             without recognising that growth is needed. There is a risk that the crisis-struck
           2,5
                 jan   apr    jul   okt   jan   apr    jul   okt    jan    apr    jul   okt   jan   apr     jul    okt
                                                                                                                                     countries in Southern Europe will pursue an anorectic economic policy, and
                             08                       09                         10                        11
                                                                                                      Source: Reuters EcoWin
                                                                                                                                     that their populations will lose motivation for being part of the EMU and EU.
Source: National statistics, Ecowin
                                                                                                                                     The increases in unemployment rates to 20% and above (closer to 50% for
                                                                                                                                     young people) are the number-one concern. Unless these falls, it will be
                                                                                                                                     difficult to hold societies together, and, when economies shrink, often the poor
                                                                                                                                     are hurt the most, and income distribution worsens. Structural policies often
                                                                                                                                     include the deregulation of markets to open up for competition, and positive
                                                                                                                                     growth effects usually come, but with a lag and not for all groups. Democracy
                                                                                                                                     gaps mean that people feel they cannot influence their future; neither the
                                                                                                                                     development of the EU, the EMU nor their own situation.
                                                                                                                                     What is needed to create a well-functioning currency union and – at the same
                                                                                                                                     time – close the democracy gaps? We need to discuss which way to go
                                                                                                                                     forward: Should the trilemma be solved, or is it better to continue with a
                                                                                                                                     transfer union, using rescue funds? And how can fiscal discipline be combined
                                                                                                                                     with growth policies? Especially, how can Europe place the young generations
                                                                                                                                     at the forefront in policy making?
                                                                                                                                     The institutions for a strong currency union are lacking, as are the democratic
                                                                                                                                     institutions. The crisis has opened wide the window of opportunity to create
                                                                                                                                     these institutions. This is the only way forward!
                                                                                                                                                                                                       Cecilia Hermansson
                                      Economic Research Department
                                                              SE-105 34 Stockholm, Sweden                                      To the Point is published as a service to our customers. We believe that we have used reliable
                                                                Telephone +46-8-5859 1000                                      sources and methods in the preparation of the analyses reported in this publication. However,
                                                                    ek.sekr@swedbank.com                                       we cannot guarantee the accuracy or completeness of the report and cannot be held responsible
                                                                       www.swedbank.com                                        for any error or omission in the underlying material or its use. Readers are encouraged to base
                                                                                                                               any (investment) decisions on other material as well. Neither Swedbank nor its employees may
                                                                   Legally responsible publishers                              be held responsible for losses or damages, direct or indirect, owing to any errors or omissions
                                                                             Cecilia Hermansson                                in To the Point.
                                                                                +46-8-5859 7720




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To the Point, No.1, January 30, 2012

  • 1. To the Point Discussion on the economy, by the Chief Economist January 30, 2012 The full monty: how to build a strong currency union while closing democracy gaps  The institutions for a strong currency union in Europe are still lacking. To be effective, the EMU needs fiscal cooperation (or union), supranational bank regulation, and a central bank as lender of last resort to banks and sovereigns.  Euro zone politicians may opt for the less solid β€œtransfer union” approach, using rescue funds instead, but then these funds need to be larger and more flexible.  The EMU is threatened by β€œdemocracy gaps”, which politicians need to address, Cecilia Hermansson not least of which how to meet the challenges for young generations. Group Chief Economist Economic Research Department Fundamentals missing for a well-functioning currency union +46-8-5859 7720 cecilia.hermansson@swedbank.se When Swedes evaluated whether or not to enter the EMU through the referendum in 2003, the focus was on economic effectiveness, stabilisation tools, and political aspects of membership. Especially, a situation where Sweden experienced an asymmetric shock was viewed as a risk, as it would be impossible to use sovereign monetary policy to correct, e.g., an unfavourable cost structure. In addition, the mobility of production factors, such as labour, within the union, was considered insufficient. This was subject of much debate, as labour market mobility was part of Professor Mundell’s optimum currency area (OCA) theories. There were also those, e.g. Professor Assar Lindbeck, who argued that the EMU did not have effective ways of transferring resources between countries. The focus of the 2003 referendum, however, was not on the deficiencies of the EMU, but on Sweden’s prerequisites to become a member, not least since Sweden had just recovered from a deep financial crisis at the beginning of the 1990s and was not yet confident it knew how to pursue effective economic policy – which is certainly no longer the case! There should have been more focus whether the fundamentals for a well-functioning currency union would be in place. According to Professor Barry Eichengreen, the prerequisites for a currency union are strong fiscal cooperation or a fiscal union, one bank regulator/supervisor (not 17) and a central bank that is without doubt a lender of last resort (with regard to both banks and countries). The Brussels-based think tank, Bruegel, discusses the euro crisis and the β€œimpossible trilemma” of no shared responsibility for public debt, bank sovereign independence and a strict prohibition of monetary financing. Its director, Professor Jean Pissay- Ferry, argues that the euro zone faces this new trilemma (inspired by Mundell’s famous trilemma of free capital flows, stable exchange rates and independent monetary policy). He builds on Eichengreen’s argument, and finds that the EMU does not have the fundamentals in place, in any of the three areas. The Stability and Growth Pact (SGP) was not followed by the members, not even by Germany. The no-bail-out clause (Article 125 of the EU Treaty) was at the forefront of EMU policy, until the debt crises in periphery countries made it impossible to stick to the Treaty. Without changing the Treaty, rescue funds, (the EFSF) have been set up and, de facto, the EMU has turned into a transfer union despite the intention to avoid this outcome. Monetary financing is not allowed by the Treaty (Article 123), but there No. 1 have been ways to circumvent this rule, e.g., through ECB lending to banks at 2012 01 30 favourable terms to facilitate their purchases of sovereign debt bonds. Bank regulation and supervision are still national. Pan-European stress tests have been given, but there is no supranational bank regulator, which means that national interests take over, at the expense of transparency and effective crisis management.
  • 2. To the Point (continued) January 30, 2012 Democratic shortages must be taken seriously Chart 1: EMU:s trilemma All three of these institutions must be in place to make the EMU work (the β€œfull monty”), but politicians have different views on which of the three they would like to focus on. France, in particular, would like to start by giving more responsibility to the ECB as lender of last resort, while Germany has a stronger focus on using the fiscal compact to set fiscal discipline (even if a full-fledged fiscal union is probably not preferred by anyone). The problem with allowing more support through the ECB, without creating sufficient fiscal discipline, is moral hazard and poorly working incentives. The problem with focusing only on fiscal discipline is that the current crisis will not be handled, and a systemic bank crisis evolves and confidence falls. Instead, transfers are made through the rescue funds – types of support that would probably not be needed if the three fundamentals were in place. It seems as if politicians and voters alike are not ready for either a fiscal union, Source: Bruegel or a β€œfinancial union” and thus the ECB:s role would continue to be limited, at least in theory. Then, the solution with rescue funds would prevail, but, in order to strengthen confidence so that the expectations of a break-up of the EMU can recede, the size and flexibility of these funds must be increased. Politicians are focusing on taxing financial transactions and creating a fiscal Chart 2: Unemployment rates in euro zone compact. The first idea picks up on voters’ anger with banks and will not help 25,0 to solve the crisis; there is rather a risk that the financial sector will lose out in 22,5 Europe, and that would be negative for economic growth. The second idea is 20,0 necessary to create confidence for other support, e.g. from the ECB and IMF, 17,5 and would perhaps be a first step towards stronger fiscal coordination. Creating Spain Greece such a compact, however, is not sufficient for managing the current crisis, as it Percent 15,0 would have to be coupled with sizable support through the rescue funds. 12,5 Euroland 10,0 Even if symmetric growth is not the most important for a currency union – US 7,5 Germany Wyoming and Texas do have different economic structures and growth developments – it is not possible to build a well functioning EMU and EU 5,0 Japan without recognising that growth is needed. There is a risk that the crisis-struck 2,5 jan apr jul okt jan apr jul okt jan apr jul okt jan apr jul okt countries in Southern Europe will pursue an anorectic economic policy, and 08 09 10 11 Source: Reuters EcoWin that their populations will lose motivation for being part of the EMU and EU. Source: National statistics, Ecowin The increases in unemployment rates to 20% and above (closer to 50% for young people) are the number-one concern. Unless these falls, it will be difficult to hold societies together, and, when economies shrink, often the poor are hurt the most, and income distribution worsens. Structural policies often include the deregulation of markets to open up for competition, and positive growth effects usually come, but with a lag and not for all groups. Democracy gaps mean that people feel they cannot influence their future; neither the development of the EU, the EMU nor their own situation. What is needed to create a well-functioning currency union and – at the same time – close the democracy gaps? We need to discuss which way to go forward: Should the trilemma be solved, or is it better to continue with a transfer union, using rescue funds? And how can fiscal discipline be combined with growth policies? Especially, how can Europe place the young generations at the forefront in policy making? The institutions for a strong currency union are lacking, as are the democratic institutions. The crisis has opened wide the window of opportunity to create these institutions. This is the only way forward! Cecilia Hermansson Economic Research Department SE-105 34 Stockholm, Sweden To the Point is published as a service to our customers. We believe that we have used reliable Telephone +46-8-5859 1000 sources and methods in the preparation of the analyses reported in this publication. However, ek.sekr@swedbank.com we cannot guarantee the accuracy or completeness of the report and cannot be held responsible www.swedbank.com for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may Legally responsible publishers be held responsible for losses or damages, direct or indirect, owing to any errors or omissions Cecilia Hermansson in To the Point. +46-8-5859 7720 2