The future of the Euro after the Great Recession by Javier Andrés and Rafel Domenech


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The future of the Euro after the Great Recession by Javier Andrés and Rafel Domenech

  1. 1. /JAVIER ANDRES * / RAFAEL DOMENECH**/ The future of the Euro after the Great Recession 1Summary; 1. Introduction; 2. From the Great Moderation to the GreatRecession; 3. The imbalances in Europe and in the EMU; 4. The newEuropean governance and the future of the Euro; 4.1. Changes in fiscalgovernance; 4.2. Financial integration; 4.3. Economic integration; 5.Conclusions.SummaryIn this chapter we shall analyse the challenges the Eurozone is facing andproposals to deal with them via improved economic governance. To do so,* Javier Andrés is professor of Fundamentals of Economic Analysis at the University ofValencia and visiting professor of the University of Glasgow.** Rafael Doménech is Chief Economist of Developed Economies, BBVA Research andProfessor of Fundamentals of Economic Analysis at the University of Valencia. The authors thank A. Deligiannido, A. García, M. Jiménez, and E. Prades for their assis-tance and comments on this work, as well as the help from CICYT projects ECO2008-04669 and ECO2011-29050. 15
  2. 2. The future of the Euro after the Great Recessionwe shall first examine the reasons behind the accumulation of significantimbalances in the developed economies and among the EMU countries,mainly since 2001 until the crisis in 2007, as a result of a pattern of unsus-tainable growth in many developed economies. Secondly, we shall offer anin-depth analysis of the significance of such imbalances and the heteroge-neity which exists between EMU countries. Lastly, we shall study the cha-llenges presented by the improvement of the economic governance of theEMU from a fiscal, financial and economic integration perspective, whichshall determine its economic future in the short and long term.1. Introduction The international economic crisis which begun in 2007 ishaving an extraordinary impact on the European economy, and forthe coming decades, will leave a deep mark in many of its mem-bers. The crisis has shown that the growth process undergone bet-ween 1994 and 2007, particularly following the creation of theEconomic and Monetary Union (EMU) in 1999, had entered intoan unsustainable dynamics in the long term. The appearance ofimportant macroeconomic imbalances among EMU members wastaking shape within the framework of steady growth, inflationunder control, very low interest rates and a very reduced risk assess-ment (partly as a result of the disappearance of currency risk) in thecontext of a world saving glut. Although the Eurozone as a wholepresents smaller aggregate imbalances in terms of deficit and pri-vate, public and foreign debt than, for instance, the US or theUnited Kingdom, the expectations of economic convergence16
  3. 3. The Future of the Euroamong Eurozone countries and the appearance of financial bubbleswith the promise of high yields, led to very significant capital flowsamong its members. This added to a spiralling increase in house-hold debt and businesses in some of the member countries, gene-rating very considerable and longstanding deficits in currentaccount balances. These expectations petered out sharply as of thesubprime crisis of 2007 and, since then, Europe has been experien-cing different surges of financial crises, economic crises and sove-reign debt crises, which have been following on and feeding offeach other over time.2 The result of this complex situation has beenthat, albeit with differences in the intensity and the severity of theproblems (see, for instance, Doménech and Jiménez, 2010), a sig-nificant number of European countries have experienced a situa-tion similar to that of the sudden stops experienced in the past bysome emerging economies, leaving public and private sectors heavilyindebted and, in some cases, extremely high rates of unemployment. The aim of this chapter is to analyse the changes required by theEMU and proposals with which to face such challenges with suc-cess. In order to understand what the problems are and, therefore,their possible solutions, in the second section we analyse the rea-sons why important imbalances accumulated in the developed eco-nomies and among the EMU countries during one of the most sta-ble periods of economic prosperity in the last decades (the GreatModeration), which nevertheless gave way to an unsustainable2 Shambaugh (2012) performs an excellent analysis of the interaction between fiscal,financial and economic crises in the Eurozone. 17
  4. 4. The future of the Euro after the Great Recessiongrowth pattern in many economies. In the third section, we offeran in-depth analysis of the magnitude and implications of suchimbalances throughout the crisis, which are well summarised in theExcessive Imbalance Procedure (EIP) recently implemented by theEU, as well as the current heterogeneity among EMU countries. Thefourth section analyses the challenges of improvement of economicgovernance of the EMU from a fiscal, financial and economic inte-gration standpoint, which shall determine its short and long termeconomic future. Lastly, the fifth section presents the main conclu-sions reached in this paper.2. From the Great Moderation to the Great Recession In the period between the mid-1990s and 2007, developed eco-nomies enjoyed one of the greatest economic growth periods,known as the Great Moderation due to the low volatility of growthrates in those years. Graph 1 shows evidence of this for the US andthe EMU in terms of GDP per person of employable age. As can beseen, from the mid-1990s to 2007 there was sustained growth, withlevels well above the historical trend estimated since 1970 for bothgeographical areas. In fact, the growth in GSP per person of emplo-yable age was slightly higher in the EMU than in the US, althoughnot enough to bridge the gap between both economies. The Great Moderation generated the perception that economiccycles would have less volatility, as a result of better managed eco-18
  5. 5. The Future of the Euronomic policy (see, for instance, Galí and Gambeti, 2009, or thereferences appearing in this article). In fact, these high growth rateswith low volatility came hand in hand with inflation under con-trol and low interest rates across the board of financial assets, withpractically inexistent risk premiums in many cases as a result of theunderassessment of the risk. In light thereof, some analysts went asfar as to proclaim the disappearance of the economic cycle and thecapacity to avoid significant economic recessions. It was the com-binations of these forces which fed the financial imbalances which,for economists like Rajan (2005) or Borio & White (2005), amongothers, are behind the crisis which began in 2007. There are various economic factors which contributed to genera-te this combination on which the Great Moderation was erected. Inthe first place, the central banks of the developed economies carriedout a low interest rate policy or money glut, as a result of: i) the dropin the inflation of sellable assets following the inrush of exportingcountries in the international economy with a very abundant andcheap workforce and depreciated currencies; ii) the benign neglectpolicy in regard to the high prices of financial and real estate assets(Bordo & Jeane, 2002, or Bean 2004 & 2010); and iii) the attempt toprevent the recession in the US, following the burst of the techno-logical bubble, or in Germany, following the costly process of reu-nification and the burst of its real estate bubble. Secondly a savings glut took place on a worldwide level inChina, Japan, Germany, oil producing countries or the pension 19
  6. 6. The future of the Euro after the Great Recessionfunds of developed economies. Thirdly, and as a response the savings glut in some countriesand sectors, a formidable increase took place in the demand of safeassets, moving from the pre-eminence of individual savers to thatof large sovereign funds, investment funds or pension funds whichprioritize safety over yield and which seek to channel savingstowards fixed income rather than towards the acquisition of anyother kind of asset. At the same time that the demand for safefinancial assets (i.e. AAA) increased, there was a relative scarcity ofsuch assets in the case of sovereign debt, due to the fiscal consoli- Chart 1 GDP per person of employable age in the US and in the EMU Source: OEDC (2012) Economic Outlook Database.20
  7. 7. The Future of the Eurodation taking place simultaneous in many developed economies asa result of the high growth in GDP. This surplus demand for safeassets created enormous pressure in the financial markets and incertain types of assets, which in turn led to the appearance of bub-bles in certain market segments. The pressure was such that finan-cial deregulation and engineering came to the rescue, enabling theresponse of the financial markets to this scarcity in AAA assets tobe the creation of multiple derivatives and the issue of huge volu-mes of asset backed securities, as shown in Graph 2. In turn, thisgenerated enormous liquidity to fund those assets acting as theunderlying assets (for example, mortgages on homes), thus crea- Chart 2 Issue of Asset backed Securities 1985-2011 Source: SIFMA 21
  8. 8. The future of the Euro after the Great Recessionting a circle in which asset demand stimulated supply, which inturn was fed back into the process by boosting demand with thecreation of new assets. As a result of this process, a specialization in asset productiontook place on an international level, leading to enormous hetero-geneity by country, sector and agents. Whereas some countriesgenerated a surplus in net savings, others (US, Spain or Ireland) res-ponded to the very low interest rate incentive by generating thereal investments which served as the underlying assets for finan-cial securities. The US produced assets on a world scale consideredsafe by the markets, thanks to the specialization of its financial ser-vices. Other countries, such as Spain and Ireland, carried out asimilar role, but on a European scale, producing assets backed bysafe collateral (homes) or with no collateral, but issued by financialinstitutions deemed to be safe, which attracted savings funds orlarge European banks. In fourth place, the creation of the EMU meant the disappearan-ce of exchange rate risk among its members. This removed an impor-tant barrier to capital flows within the EMU and encouraged the pre-viously described process. But its effects went even beyond the disap-pearance of currency risk. In the international financial markets, aswell as in the EMU countries, expectations that the greater monetaryand economic integration ensured the economic convergence of itsmembers were generated, which justified the disappearance of anytype of risk premiums (see Ehrmann et al, 2011).22
  9. 9. The Future of the Euro Graph 3 clearly shows the almost full disappearance of risk pre-miums for countries becoming part of the EMU. Without doubt,Greece was a paradigmatic example of this process, going from fun-ding at 25% in 1993 to do at the same interest rate as Germany, follo-wing its entry into the Eurozone. Chart 3 10 year public debt interest rates in the EMU, 1995-2011 Source: ECB, Bloomberg The implications of such expectations of economic convergencewere very important in terms of imbalances in the current balance.Under the assumption that a real and economic convergence pro-cess was taking place, well beyond the nominal, it seemed naturalthat capital should flow towards the economies with lower per capi- 23
  10. 10. The future of the Euro after the Great Recessionta incomes, as economic theory predicts (see, for example, Barro,Mankiw & Sala-i-Martin, 1995). In fact, as the risk premiums were disappearing, the correlationbetween the savings rated and investment rate were reduced. Aswas already anticipated by Blanchard and Giavazzi (2002), since1999 to the start of the crisis, the Feldstein-Horioka paradox disap-peared completely, as shown in Graph 4. Coinciding with thereduction in the typical deviation of risk premiums, which reached Chart 4 Typical deviation of risk premiums and correlation between the rate of investment and the rate of savings, EMU, 1993-2011 Source: Bloomberg24
  11. 11. The Future of the Euroalmost zero as of 1998, the correlation between the national invest-ment rate and the savings rate was observed to have been nil oreven negative, compared to the positive and statistically significantvalues of the beginning of the nineties. In fifth place, a permissive regulation, together with reducedinterest rates and very high competition in the financial sectorgenerated the incentives required for the generation of profit to bedone via transaction volume instead of via price margins (mainlyinterest rates), favouring a very important leveraging of broad seg-ments of the private sector. One of the results of this process wasthe intensification of a new banking business model, based on thegranting of collateral backed loans, the generation of financialassets from such loans and the distribution thereof as asset-backedsecurities in asset packages (originate to distribute) which transfe-rred credit risk in full to the purchasers of these new generatedassets. Compared with the traditional bank business, in whichfinancial institutions that grant the credits keep the risk on theirbalance sheets, this new business model led to greater intercon-nection of the balance sheets among financial institutions all overthe world and a significant increase in contagion risk.3. The imbalances in Europe and the EMU The financial crisis was preceded by a period of economic prospe-rity, measured by conventional indicators of growth, macroecono- 25
  12. 12. The future of the Euro after the Great Recessionmic stability and inflation, during which enormous imbalances of afinancial and competitive nature have been created. However, aglance of the macroeconomic picture of the EMU reflects a situationof balance which we do not find in other important economicregions of the world (Table 1). Both the deficit and public debt levelsand the net foreign positions and private indebtedness are generallylower to those recorded in the United States or the United Kingdom. However, the EMU has had other problems hanging over it whichhave led the economy of the region – and that of the whole of theEU by extension – to the situation of stagnation which it is currentlyundergoing. Some of these problems are of a structural nature, andothers are related to the extraordinary disparities between memberstates in their key indicators to which, until very recently, we hadpaid little attention. Among the first are demographic evolution andlow productivity growth which in turn have provoked a limited rateof growth in employment. But the disparities and the heterogeneitywithin the EMU are the most outstanding imbalances, as they callfor a serious amendment in the operation of the Euro, whose mainobjective was to accelerate convergence among countries who adop-ted the single currency along with other common institutions. The European Commission has recently implemented a pro-gramme to monitor a number of indicators to detect and trackmacroeconomic and financial imbalances in countries within theEU (the EIP). One of these indicators summarises, over all others,the nature of the main problem facing the European economy:26
  13. 13. The Future of the Eurothe gradual and persistent disparity in the current account of itsmember countries. Although the EMU and the EU are economieswhich can be described as economies which contribute (anddemand) little net savings to (and from) foreign savings, theiraggregate results is the sum of extremely disparate realities. AsLane (2010) points out, in 2010 European countries accounted forapproximately one third of all current account deficits and sur-pluses worldwide. As can be seen in Graph 5, the current accountdeficits and surpluses of the EMU have gradually polarised fromlevels ranging between the [-3%-, +3%] interval, in proportion tothe GDP to position itself outside of this range and even persis-tently above it by 5%. The underlying causes and macroeconomicimplications of this type of imbalance are extremely complex. Table 1 Debts and deficits in the EMU, US and United Kingdom (% GDP) EA17 US UK Budget balance of 2011 -4.4 -9.6 -8.9 public administrations Debt of public 2011 87.6 100.0 84.8 administrations Household debt 2010 67.3 92.1 106.1 Corporate debt 2010 119.1 74.6 123.7 Current account 2011 0.1 -3.1 -2.7 balance Net international 2010 -7.2 -17.0 -13.9 position Sources: AMECO, Haver, IMF, national sources and BBVA Research 27
  14. 14. The future of the Euro after the Great Recession It is true that this polarisation is not an exclusively Europeanphenomenon, as it happens in parallel with the so-called “globalimbalances” generated during the recent globalisation process.However, in contrast to what is happening on a world scale and par-ticularly in a series of developed countries (the Anglosphere) andemerging countries (particularly China) in Europe there is a positi-ve correlation between levels of income per capita and sales deficit,so that the capital flows from the more advanced countries to theless developed. This has rendered such imbalances less conspicuous,as they have been associated with the real convergence process. Thetraditional view considered foreign indebtedness as a natural con-sequence of the catching up process during which the countriesundergoing rapid growth required foreign savings to fund strongdomestic investment in commercial goods. Thus, the availability ofsavings and the Euro allowed for the funding of the productivityconvergence without financial and exchange rate strangulation.The international allocation of savings was deemed to be optimal(“consenting adults”, Obstfeld, 2012), and there was no reason forpublic political intervention – what became known as “benignneglect” by Blanchard and Giavazzi (2002) or Edwards (2002). It is not easy to determine an optimal level, or even an adequateone, for the current account deficit which already reflects the gapbetween domestic savings and investment in a country which isassumed to have been optimally determined by consumers and busi-nesses, unless it is associated with high public deficit, in which casewe would be dealing with a fiscal problem. Moreover, a country may28
  15. 15. The Future of the Eurohave a deficit current account without having a serious foreignfinancing problem, or may have it despite having a regularisedaccount, in this case because despite a reduced net capital flow, whatmatters in the event of a financial crisis is the size of the gross flows,as nothing guarantees that national savers are willing to funddomestic liabilities should the international markets become una-vailable. However, the evolution of the current account of EMU coun-tries (EU) reflects more deep-rooted problems where the adjustmentrole of the market mechanism has proven insufficient and in whichgross financial flows have grown in a fast and imbalanced way. Chart 5 Current account balance (% GDP) Source: BBVA Research with data from national sources 29
  16. 16. The future of the Euro after the Great Recession The deficits have not been linked with productivity convergen-ce, as is evident in the cases of Spain, Portugal and, to a certainextent, Ireland, which accumulated growing deficits despite theslow growth of total productivity of the factors. As can be seen inGraph 6, productivity grew by 1% on average, whereas the currentaccount balance varied between surpluses over 5% (theNetherlands and Germany) and deficits of 10% (as in Portugal andSpain). In fact, it has not only been the lure of investment butmainly the fall in savings in peripheral countries which has causedthe gap in commercial deficit which has exceeded both in volume– percentage of GDP – and in persistence, that observed in manyemerging countries prior to the crisis of the eighties and nineties.Moreover, much of the foreign financing to the receiving countrieshas not been channelled through direct and portfolio investment,but by way of bank bonds, which increases the risk of bank crisesand ‘sudden stops’ (Jaumotte and Sodsriwiboon, 2010; Land,2010). However, the most worrying characteristic of the unequal per-formance of the current account in Europe is its persistence. Farfrom being a transitory phenomenon, the divergence betweencommercial balances has sharpened until 2007 (see Graph 5). Thedesign of the Euro took into account that the absence of owncurrency would hinder the traditional adjustment to which mostcountries resorted in times of crisis in the balance of payments.The impossibility of this recourse to devaluation has not comehand in hand with the strengthening of real devaluation mecha-30
  17. 17. The Future of the Euronisms, that is, with a more flexible response by prices and salaries.Between 2000 and 2010, enough time has lapsed to have expectedthat the countries with most foreign debt and strong real apprecia-tions should have begun a process of correction towards a surplusin the commercial balance. Nevertheless, this has not been thecase. The correlation between the commercial deficit and the netforeign position was positive in 2011 and in 2010 (Graph 7) as ithad been in the last decade, indicating that the privatesavings/investment balance does not seem to respond to the cumu-lative net foreign position. Chart 6 Current Account Balance in 2007 (% of GDP) and average productivity growth bet- ween 2000 and 2009. Source: BBVA Research based on AMECO 31
  18. 18. The future of the Euro after the Great Recession In 2010 only four EMU countries had a net positive foreign posi-tion – Belgium, Germany, the Netherlands and Finland – and onlyFinland had managed it after correcting a very negative position in2001 (that is, after a decade of foreign rapid growth and surplus).Practically all other EMU countries saw their net indebtednessincrease substantially or, at best, such as in France or Austria, theymanaged a moderate reduction thereof within the first ten years ofthe single currency. Therefore, the performance of the current account is a very use-ful indicator – although naturally not infallible – of the way inwhich a country responds to the commercial and financial globa-lisation process and to the existence of other types of imbalancesassociated with private sector debt, both financial and non-finan-cial. Before reviewing these indicators for the EMU (EU), it is worthasking why the (market) adjustment mechanisms have failed inthis case and what the risk of this situation is happening again inthe future. The conventional current account approach indicates thatfinancial flows are a mere counterpart of commercial flows, so thatsustainability of foreign debt must be guaranteed by the expecta-tion of future current account surpluses or, what is the same, by asignificant proportion of the commercial goods production in theeconomy. Foreign financing is no at risk while foreign investorsconsider the economy to be competitive. The domestic economymust maintain a high productivity growth rate and competitive32
  19. 19. The Future of the Eurolabour costs, as the opposite would render the foreign deficitunsustainable, foreign investment would drop, reducing prices andsalaries and improving the foreign balance. In this way, given rea-sonable elasticity in the demand of exports and imports, theperiods of real appreciation and foreign deficit can be reversed wit-hout deep structural changes. However, this market mechanism has not worked in peripheralEurope. Foreign funding has been used to a large extent to fund Chart 7 Current account balance and net international position Source: BBVA Research based on Eurostat 33
  20. 20. The future of the Euro after the Great Recessionnon-commercial goods, leading to strong expansion of demand, ofprices and of labour costs (see Graph 8). Despite the loss of com-petitive capacity, the appeal for foreign lenders continues providedthe value of the asset with real guarantees – such as homes – con-tinues, which is perceived as relatively safe. Thus, the worseningcompetitiveness is the effect and not only the cause for the dete-rioration of the current account. But the existence of high com-mercial deficit is not corrected of its own accord nor is it done in asmooth and orderly manner. When the bubble bursts and prices ofthe assets used as guarantees plummet, foreign investors perceivethat the national economy is no longer able to guarantee theirdebt, leading to the well-known processes of flight to quality,increase in the cost of debt and, in extreme cases, to sudden stops. This integration process has led to a number of other imbalan-ces in the European economies. The objective of the EIP is to gobeyond the control of deficit and debt, and to follow a number ofeconomic indicators which enable the detection of inadequatemacroeconomic development in a country and can lead to locali-sed financial crises and even contagion in the future. Such indi-cators come hand in hand with a number of ‘limits’ that are con-sidered to be security measures which, when exceeded by acountry, special tracking must be carried out by the Commission.If an economy is showing imbalance in several of these indicators,it must propose a plan of action for correction thereof which, ifnot suitably applied, might result in some form of political or eco-nomic penalty. The list of indicators is the following (the limits34
  21. 21. The Future of the Euroabove which a form of relevant imbalance is detected appear inbrackets): current account balance (% GDP, -4%, 6%); net inter-national position (% GDP, -35%); real effective exchange rate(variation rate, -5%, 5%); export market share (growth rate, -6%);nominal unitary labour cost (growth rate, 9%); cost of housing(growth rate, 6%); credit flow to private sector (% GDP, 15%); pri-vate sector debt (% GDP, 1605); public debt (% GDP, 60%); andunemployment rate (10%). Chart 8 Growth of nominal salaries and real productivity Source: BBVA Research based on Eurostat 35
  22. 22. The future of the Euro after the Great Recession The first report issued on the monitoring of these indicators shows that in the third year since the start of the crisis (2010), the imbalances accumulated in recent years are far from being correc- ted, some of them having worsened since 2007 (Table 2). Greece, Portugal, Ireland and Spain are the countries with worse qualitati- ve results. They belong to the Eurozone periphery, where they fail in at least five of the ten criteria.3 It is within the framework of such imbalances that we must interpret the fiscal crisis that has been reflected in the general growth of risk premiums of sovereign debt in Europe, especially in peripheral countries – although not exclusively. The levels of public debt in the EMU are comparable to those in the rest of the develo- ped world, both if we consider the region as a whole or the coun- tries within it separately. As is shown in Graph 6, only in 2008 three EMU countries (Greece, Italy and Belgium) had a public debt above that of the US and in any case much lower than that of Japan. The growth in public debt during the crisis period places EMU countries – with the exception of Greece and Ireland – in the realm of 20%, similar to what had happened in most of the deve- loped countries. Therefore, behind the sovereign debt crisis there are issues related to the economic governance of the EU in general and the Eurozone in particular. But also, deeper reasons which have3 The situation is worse if we take into account that indicators such as the growth rateof housing prices and credit for the private sector are nowadays within the limits accep-ted by the MIP as a result of the extraordinary restriction on credit suffered by most EUeconomies. 36
  23. 23. The Future of the Eurobecome evident following the segmentation of the financial mar-kets due to the crisis. On the one hand, we have the demographicand structural characteristics of most of the countries, whichherald for the future a scenario of lesser growth than that beforethe crisis. Graph 9 shows the growth rates up to 2007 and the fore-casts made by the IMF up to 2015 for EMU countries, the UnitedKingdom, Japan, and the US. The aging population and its effects on participation in thelabour market, the low savings rates – with the ensuing difficultiesin funding investments – and the slow rate of productivity growthexplain such expectations, which in turn severely affect the capa-city to absorb the strong increase in public indebtedness. In second place, the economic crisis itself has generated anadditional burden on public finances by way of contingent liabili-ties, the realisation of which shall depend on the performance ofthe private debt and the need to apply measures to assist in thereconversion of the financial sector. As stated by Reinhart & Rogoff(2008 and 2009), one of the main consequences of financial crisesis that a large part of the private sector debt becomes public. Table3 (ECB, 2012) shows the impact on public finances of the twomain contingent-type averages within the EMU: provisions for theEuropean Financial Stability Facility (EFSF) and the guarantees forthe banking sector. The sum of both would mean an additionalimpact on the public debt in the EMU of almost 13% of the GDP.It is true that such contingencies do not necessarily have to mate- 37
  24. 24. 38 Table 2 Imbalances at the EMU Source: European Commission (2012): First Alert Mechanism Report (moving averages, 3 or 5 years) The future of the Euro after the Great Recession
  25. 25. The Future of the Eurorialise, but it is also true that provisions have proven insufficientand have had to be extended in successive programmes. Chart 9 GDP Growth in 2007 and 2015 Source: IMF (2012) Lastly, the aging of the population gives way to the generationof implicit liabilities which are not considered in public debt figu-res but should be taken into consideration when evaluating thesustainability of public finances (Cecchetti, Mohanty andZampolli, 2010). In 2009 the IMF (IMF, 2009) calculated the sum ofimplicit and contingent liabilities in securities exceed – in presentvalue – 400% of the average GDP of the G20. Of these, those of acontingent nature associated with the crisis account for approxi- 39
  26. 26. The future of the Euro after the Great Recessionmately one tenth, whereas that associated with an aging popula-tion – pensions and social security – account for much higherimplicit obligations. As a whole, this type of liability will demanda remarkable effort from public finances in the future. Cecchetti,Mohanty and Zampolli (2010) place the additional permanentfinancing required to meet such obligations at between 5 and 10GDP points assuming a public debt at levels similar to the currentones in developed countries. In summary, some European economies may have reached debtlevels which exceed or are dangerously close to their fiscal limits,defined as the maximum level of debt which a country is able tofund. The fiscal limit depends on the political will of its citizensand the capacity to increase income by means of tax rate rises (Bi,2012 and Leeper & Walker 2011) which makes it specific to eachcountry. This might explain, at least in part, the differences obser-ved in risk premiums between countries with similar levels of debtor even that some countries pay a higher cost of financing thatothers with much higher levels of debt. Moreover, the relationshipbetween the risk premium and the fiscal limit is non-linear, incre-asing rapidly when fiscal performance places debt at such levelsthat the likelihood of reaching the limit is significant (Bi, 2012).That is to say, in order to observe significant risk premiums, it isenough for investors to understand that the fiscal strategy of acountry leads it to a fair likelihood of reaching the maximum levelof debt financed, even if the probability of this taking place in theshort term is very small. This probability in turn grows over the40
  27. 27. The Future of the Euroeconomic cycle, which obliges countries with greater volatility ineconomic activity and unemployment to opt for stricter fiscalrules.4 Table 3 Contingent Obligations of the governments 2008-2010 Banking sector EFSF guarantees Belgium 7,3 12,7 Germany 8,22 3 Estonia 12,46 0 Ireland 42,8 Greece 25,8 Spain 8,61 6,2 France 7,97 3,1 Italy 8,78 2,7 Cyprus 8,78 15,7 Luxembourg 4,66 3,2 Malta 10,91 0 The Netherlands 7,32 6,1 Austria 7,19 5,7 Portugal 9 Slovenia 10,23 4,4 Slovakia 11,05 0 Finland 7,34 0 EMU 7,71 5,2 Source: BCE4 When the economies reach this limit, the efficacy of the fiscal and monetary policyis substantially reduced and both instruments no longer have the expected effects oneconomic activity. The fiscal multipliers are reduced and the monetary authority losesthe capacity to control inflation, irrespective of the aggressiveness of its monetarypolicy. 41
  28. 28. The future of the Euro after the Great Recession4. The new European governance and the future of the Euro The economic crisis has highlighted the need to carry outimportant changes in European governance. It is obvious thatthere have been failures in coordination in the economic policyand mistakes in the policies adopted by national government,which have generated a sovereign debt crisis and a financial crisis.And it is also obvious that Europe was not first resorting to thesupranational institutions and bodies to prevent the crisis and toprovide a rapid and efficient response once it had begun. The EU,and particularly the EMU, need to improve their economic gover-nance in at least three areas: fiscal, financial and economic inte-gration. Below we shall analyse each of these aspects and the cha-llenges faced in each by the EMU.4.1. Changes in fiscal governance In regard to fiscal integration, over recent months importantinroads have been made, among which are the Stability,Coordination and Governance Treaty and the creation of theEuropean Stability Mechanism (ESM). The new Treaty, which shallcome into force on 1 January 2013, has been signed by all EU coun-tries except for the United Kingdom and the Czech Republic, andaims to make public finances sustainable and prevent the onset ofexcessive public deficits, in order to safeguard the stability of theEurozone as a whole. In fact, this Treaty can be interpreted as asecond version of the Maastricht Treaty of 1992, with the differen-42
  29. 29. The Future of the Euroce that whereas the former determined the conditions to enter theEMU, the new treaty can be said to detail the conditions to be metby the members of the EMU to continue to belong to the Eurozone.To this end, the Treaty introduces specific rules (the structural defi-cit may not exceed 0.5% of the GDP, as of a date to be determinedby the European Commission, and a public debt below 60% ofGDP) and automatic mechanisms which enable the adoption ofcorrective actions in the event of deviation from targets. The rules introduced by the Treaty are in general well designed.When establishing an objective in terms of structural fiscal balance itallows for the influence of automatic stabilisers, the minimum beingbetween 0.5% of structural deficit and the deficit limit of 3%.However, a good design does not necessarily guarantee a good imple-mentation, as was the case with the Stability and Growth Pact (SGP).It is true that the new Treaty entails a criterion of “reverse majority”:from now on the adoption of corrective or disciplinary mechanismsproposed by the European Commission must be rejected by a majo-rity, whereas in the SGP the majority needed to be reached in orderto approve such proposals. It is also the experience of the current debtcrisis has led to an accumulation of collective knowledge which shallprove very useful when adopting the right decisions in the future toprevent new crises of this kind. Just as eighty years later the FederalReserve is currently preventing some of the well-known mistakeswhich were made during the Great Depression of the 1930s, theEuropean Commission and the European Council shall endeavour toprevent imbalances similar to those we are currently undergoing. 43
  30. 30. The future of the Euro after the Great Recession Available empirical and theoretical literature (see, for instance,Andrés & Doménech, 2006, and the references included in thispaper), indicates that use of fiscal rules has proven useful in thecontainment of public debt and the deficit, without the effective-ness of the automatic stabilisers adversely affecting the effective-ness of the discretionary fiscal policies. Therefore, the fiscal ruleslike those included in the Stability Treaty do not have to be animpediment for the fiscal policy to carry out its duty of stabilisa-tion of economic cycles. Quite the opposite: when the economicagents know, that as a consequence of the existence of such rules,expansive fiscal policies in the short term shall be offset in themedium term by counter-adjustment measures in order to preventthe accumulation of public debt, the effectiveness of these discre-tionary stabilisation policies increases, as has been proven byCorsetti, Meier and Müller (2011). In any event, it shall be very difficult to achieve an optimalimplementation of the Treaty. In the first place, because all govern-ments are often too complacent when allocating probabilities topossible risk scenarios which may render public finances unsustai-nable. Secondly, because it is difficult that sanctions may comeabout from the European Union Court of Justice on the basis of fai-lure to meet the structural deficit targets, which depend of estima-tes of the cyclical position of the economies and the elasticity ofpublic income and expenses to this cyclical position. Nevertheless,what the Stability Treaty does provide is that, prior to reachingsanctions, the Commission may exert much greater pressure on44
  31. 31. The Future of the Euronational governments and alert markets about excessive imbalan-ces, so that it is the markets themselves that impose discipline viahigher interest rates. As for the ESM, at the ECOFIN on 30 March the decision wastaken to extend it to 500 thousand million euros, which shall beprovided over two years, and beginning on 1 July 2012. The extentto which this fund will be sufficient is still unknown, in that itshall depend on how it is used and whether it allows for fund leve-raging. Without leveraging, the fund shall only be enough to coverthe financing needs of small or medium sized economies in theEMU, but not of the big four. However, it may prove effective forspecific, selective but highly intensive interventions designed toreduce risk premiums, that is, to replace the ECB in its SecuritiesMarket Programme (SMP). In addition, if the ESM should obtainliquidity from the ECB itself, each of these entities might be able toseparately specialise in the management of a risk: the SMP wouldmanage the ‘solvency risk’ of sovereign debt and the ECB wouldmanaged the ‘liquidity risk’, thus enabling the central bank to resu-me the natural role for which it was created, as it would be creatingan EU fund, with a joint and several guarantee, instead of sove-reign debt with a national guarantee. It is very important that the intervention of the SMP is as effi-cient as possible. To this end, the Commission must be clear aboutwhich countries are solvent, with adoption of any necessary adjust-ment measures and structural reforms, and which countries need 45
  32. 32. The future of the Euro after the Great Recessionsome kind of debt restructuring. In the first case, which is clearlyapplicable to countries such as Spain and Italy, SMP interventionon risk premiums should be as intense as necessary until marketdoubt and uncertainty have been obliterated. It would otherwisebe very difficult to convince sovereign, pension or investmentfunds to purchase the public debt of such countries if Europe is notthe first to refrain from doing so. Obviously, a more decisive intervention by the SMP, whichwould lead to a rapid relaxation of the European sovereign debtmarkets, requires the adoption and follow-up of the necessaryadjustments and reforms, but with sufficient time frame so as notto asphyxiate the economic growth of the countries adopting suchpolicies. Specifically, the EU could change the fiscal consolidationstrategy which is currently being demanded from member states.The obsession for nominal deficit targets should be replaced by amore plausible, rigorous multi-annual fiscal policy strategy which,in seeking to prevent a spiralling negative growth, truly contribu-tes towards supporting sustainability in the long term of the publicfinances of all countries. Specifically, the European consolidationstrategy should be based on the following principles:1. Deficit reduction targets should refer to structural deficit inste- ad of nominal deficit, as proposed by the new Stability Treaty. This implies that countries should be asked to take specific and detailed measures to ensure a certain amount ex ante in terms of reduction in expenditure or increase in income in the46
  33. 33. The Future of the Euro coming years. If, as a result of such measures, the economic activity should be adversely affect with an impact on nominal deficit (by the mere intervention of the automatic stabilisers), the member states should not be obliged to take new savings measures in that same financial year.2. The pace of structural consolidation should be ambitious enough to ensure sustainability in the medium to long term of public finances, and gradual enough to prevent excessively adverse effects on activity and employment in the short term.3. The long term balance of public finances requires reforms which guarantee the sustainability of public systems of pen- sions and social protection. Blanchard (2011) recently recommended that, in order to return toprudent levels of public debt, it would be advisable to apply the pro-verb of “slow and steady wins the race”. A similar recommendation tothat of De Long and Summers (2012), for whom a fiscal consolidationwhich is too intense and too fast might endanger the very sustainabi-lity of public finances instead of guaranteeing it. In regard to the debate on Eurobonds, although not necessaryor sufficient, these can indeed become a useful tool in the con-text of streamlined national finances. They are not necessary, asthe Eurozone can operate without them, if the Stability Treatyand the mechanism for the prevention and correction of excessi- 47
  34. 34. The future of the Euro after the Great Recession ve imbalances work properly. And they are not sufficient to pre- vent debt crises if the fiscal or current account imbalances are not corrected. If growth is imbalanced (private indebtedness, current account balance deficit), they imply a permanent transfer of income from one country to another, which is unsustainable in the long term. But they are convenient as an efficient mechanism to ensure and pool risks in the face of asymmetric shocks and, above all, as an element of political legitimacy of the European project: European citizens must see that there are specific bene- fits to belonging to the EMU. And Eurobonds are one of these benefits, particularly now when many countries need to make considerable sacrifices and carry out adjustments and reforms. In this regard, the Eurobond proposal (blue and red) of Delpla and von Weizsäcker (2010), has the advantage that it would allow countries to benefit from risk pooling and the creation of a more liquid asset (the blue bond) than that of the debt of each of the EMU members, which would strengthen the euro as an internatio- nal reserve currency, but with the benefit of preserving market dis- cipline for national debt issued over and above 60% of GDP (red bonds).5 This proposal consists of the EMU countries pooling their5 Attinasi, Checherita and Nickel (2009) believe that this market discipline is behindthe increase in sovereign spreads between 2007 and 2009, as a result of the increase inrisk aversion and the concern for the sustainability of public finances. However, Faveroand Misale (2012) believe that this market discipline acts in an interrupted fashion overtime and, occasionally, in an exaggerated way, which in fact justifies the issue of euro-bonds. 48
  35. 35. The Future of the Europublic debt up to 60% of their GDP as senior debt under the jointand several responsibility of all members, whereas the issue ofnational debt beyond such a limit would be junior debt under indi-vidual responsibility. From this perspective, it is easy to concludethat the decision of the European Council reached in December2010 to ensure the solvency of the debt issued until June 2013, butnot that issued as of that date was a mistake, as the decision shouldhave been the opposite: ensure as of a given date all debt issuedunder 60%, which would in effective terms be equal to the creationof the Eurobonds proposed by Delpla and von Weizsäcker (2010).4.2. Financial integration As Pisany-Ferri and Sapir (2010) have pointed out, to date theEMU has worked without a European institution able to rescuetransnational financial entities and without authentic Europeanstress tests for its banking institutions. Oversight duties haveremained with national authorities and coordination problemshave been managed by means of a combination of discretionarycooperation and dependence on rules approved by the EU. One of the lessons to be learned from the current crisis is thatit is difficult to manage a financial crisis on a European scale wit-hout supranational regulators, supervisors and insurance mecha-nisms. A large part of the head start that the US has over Europein terms of crisis management and resolution is precisely due tothe non-existence or the delay in creating such bodies. The US has 49
  36. 36. The future of the Euro after the Great Recessionfederal institutions to manage banking crises, whereas Europedoes not, which renders true the saying that banks are internatio-nal when expanding and national upon demise. The problem isthat, for some governments (Ireland is a perfect example of this),banks are too large in relation to their public budgets. Likewise, the US has a federal regulation, whereas Europe hasenormous national dispersion of its regulations, despite theefforts of the European Commission and regulators to homoge-nise and converge towards a common financial regulation.Occasionally, headways made in certain rules give rise to inequa-lities among the agents who intervene in the markets, due toother rules continuing to be different. This was the case, for ins-tance, of the requirement of the European Banking Authoritythat potentially systemic banks must exceed a capital ratio of 9%before 30 June 2012, when the measurement of risk weightedassets is regulated by different rules. Banking oversight in Europe is furthermore carried out vianational supervisors instead of via a single European institution,which introduces heterogeneity in oversight levels of the financialsystem. The result of this financial fragmentation is that one can-not speak of a single market, which generates the possibility ofregulatory arbitrage, different conditions of competency, ineffi-ciencies and, in general, a disadvantage in regard to other worldfinancial areas.50
  37. 37. The Future of the Euro In summary, financial integration requires an improvement to bemade in the mechanisms through which information is shared onthe financial systems of each country and the way in which theiractivities are supervised, the harmonisation of the guarantees onbank deposits and of consumer protection regulations, the creationof European bank restructuring and rescue mechanisms, and theadvancement towards a Single Market not with more, but with a bet-ter, European regulation which, instead of adding to and prevailingover national legislation, should simplify and replace it.4.3. Economic integration With greater fiscal and financial integration the Eurozone couldoperate with less tension in the future, without ensuring the economicconvergence among countries. Is convergence of income or welfarelevels in European countries necessary? Probably not, but it is still con-venient, as has been stated earlier, to enable societies to believe thatbeing within an economic and monetary union has advantages wellbeyond those which are provided by monetary stability. One of les-sons to be learned from the Eurozone crisis is precisely that monetaryintegration does not ensure economic convergence, as this requires anadvancement in convergence of the determining factors (economic,social and institutional) of economic growth. Table 4 shows that the differences in medium and long termdeterminants of per capita income are very significant. The relati-ve position of each country has been obtained on the basis of the 51
  38. 38. The future of the Euro after the Great RecessionIMF analysis (2010), whereas the allocation of each country to oneof three groups under consideration has been carried out on thebasis of the criteria put forward by Hall and Soskice (2001). On thebasis of a number of criteria, both institutional and based on theworkings of economic relations, Hall and Soskice classify the varie-ties of capitalism into liberal economies (the US being the pro-totype) and coordinated economics (Scandinavian countries arethe paradigm). In both models (either with high or minimumcoordination), the economies can function efficiently. Market eco-nomies which cannot be classified into either group are classifiedas mixed economies. In order to transform the qualitative IMF indicator into a quan-titative one, such as analysing its correlation with per capita inco-me, values of 1 to 3 have been allocated for each of the three levelsconsidered by the IMF, where a higher score suggests a greater needfor implementing structural reforms. This enables the obtention ofan average for each country and for each of the nine indicatorswhich are shown in Table 4. The differences shown in this table arevery marked, not only between developed economies, but also bet-ween European ones. In light of this evidence it is not surprisingthat, except in the case of Ireland, the countries which have accu-mulated the most imbalances and which are suffering more formthe tensions in the debt market are precisely those which showngreater structural weaknesses and the ones which must implementthe most reforms. Countries which in turn have been classified asmixed market economies, presenting more inefficient institutions.52
  39. 39. Table 4 Structural capacity of the developed economies Source: BBVA Research (2010) based on IMF (2010) and Hall & Soskice (2010)53 The Future of the Euro
  40. 40. The future of the Euro after the Great Recession The changes in the regulations which affect the operation of thelabour, goods and services markets, trade, telecommunicationsmarkets, are easier to implement in the short term, although thechanges thereof are felt in the medium term. An example of thiscan be found in the recent reform of the labour market in Spain,which is bringing its operation in line with that of countries likeGermany (in terms of internal flexibility mechanisms) or to that offree market economies (by prioritising company agreements andopt out clauses for collective bargaining agreements). Makingheadway in these types of reforms (for example, linking salaries toproductivity) is crucial to remove the differences in competitive-ness which exist between EMU countries, particularly bearing inmind that the crisis may have had an effect on the potentialgrowth of these economies (see, for example, the EuropeanCommission analysis, 2009). However, in long term indicators such changes can take a lotlonger and, in some cases, even decades. This is the case withhuman capital. Even in the event that the many younger workersof countries such as Spain, Italy, Greece or Portugal should enterinto the labour market with the same human capital as in betterplaced countries, 25 years would be needed to half the distance forthe whole of the population of employable age.54
  41. 41. The Future of the Euro5.Conclusions The economic crisis has highlighted the excessive complacencyof the markets, agents, supranational institutions and governmentswhen interpreting the imbalances which were being generated inthe previous expansion period and the absence of supranationalinstitutions and mechanisms, firstly to prevent the imbalanceswhich led to the crisis and secondly, to provide a fast and efficientresponse once they had happened. Such institutions and mecha-nisms are necessary because the evidence shows that the marketsreact in a discontinuous way, and occasionally in an exaggeratedway, are pro-cyclical and do not generate of their own accord suf-ficient disciplinary mechanisms in the short and medium termwhenever these are needed. Insofar as the current Eurozone crisishas taken place mainly in three areas (debt crisis, banking crisisand crisis in growth and competitiveness, with huge heterogeneitybetween countries), the EU and, particularly the EMU, need toimprove their economic governance in at least three areas: the fis-cal, the financial and that of economic integration. As for the improvement in fiscal governance, the Treaty ofStability, Coordination and Governance needs to be effectivelyapplies in a preventive way and that, during its transition towardsmedium and long term structural deficit targets, this is done withsufficient rigor and the right flexibility to prevent that countriesrequired to make the most efforts in the short term should enterinto a negative growth spiral. In this regard, intervention by the 55
  42. 42. The future of the Euro after the Great RecessionESM on risk premiums should be as intense as necessary untilmarket doubts and uncertainty have been removed, so that thecountries which are implementing fiscal adjustments and structu-ral reforms have a sufficiently broad time period to enable suchmeasures to have positive effects on economic growth. As for theEurobonds, although they are not necessary or sufficient to ensu-re the operation of the EMU, they are indeed convenient as anefficient mechanism providing assurance and pooling risk in theface of asymmetrical shocks and, above all, as a political legiti-macy item in the European project: European citizens must disco-ver that there are specific benefits to being part of the EMU.Although it is difficult for such Eurobonds to become a viable ins-trument in the current situation of divergence, they must becomean essential part of the future European Treasury when the mainimbalances are well under way to being corrected through thedecisive application of the reforms in the various countries in theEU. The second area where headway must be made is that of finan-cial integration, in order to prevent future banking crises and tomanage them in a more efficient and rapid way. Europe must havesupranational financial institutions, regulators and supervisors, asthe current financial fragmentation prevents us from speaking of asingle market. An important limitation which gives rise the regu-latory arbitrage, different competency conditions, inefficienciesand, in general, a disadvantage in regard to other world financialareas competing against the European entities.56
  43. 43. The Future of the Euro Lastly, although greater fiscal and financial integration may suf-fice to enable the Eurozone to operate with less tension in the futu-re, it is worth establishing the bases for greater economic conver-gence among its members, in order to increase the political legiti-macy of the economic and monetary union project, with benefitswhich go beyond those provided by economic stability. The diffe-rences between the EMU countries in the workings of factor, goodsand services markets are very significant, as well as in long termgrowth determinants. The structural reforms undertaken to enablethe markets to work more efficiently can bring positive effects in arelatively reasonable period of time, enabling competitiveness toimprove and the imbalances accumulated during the expansionand the crisis to disappear more rapidly. In this regard, it is essen-tial to ensure the success of the Excessive Imbalances Procedureand other imbalance monitoring mechanisms, ensuring a moreefficient preventive and corrective action than that provided bythe Stability and Growth Pact. However, in terms of long termgrowth determinants, such changes can take longer and, in somecases, even decades; it shall therefore be necessary for Europe toboost the solidarity mechanisms required to accelerate this conver-gence process in a more effective and efficient way than that donein the past. To simultaneous progress on all these fronts, both at suprana-tional and national levels, is a necessary condition for the Euro toovercome this crisis and for its members to continue to form partof this project in the future. Insofar as the starting point is very 57
  44. 44. The future of the Euro after the Great Recessiondifferent in each country, the main challenge now facing theEMU is to combine in a fair way the rigor and the ambition of theadjustments and structural reforms, on the one hand, with anappropriate time frame and solidarity with all other members ofthe Eurozone, on the other. If, on the contrary, the member states should fail to show suchdetermination, any attempt towards European economic gover-nance will be due more an intention than a hard reality. TheEurozone would have an uncertain future. The alternative of aPolitical European Union, in which all necessary economic policiescould be implemented from a community Executive under thecontrol of a European Parliament and with all democratic rights, iscurrently not expected for the time being.Bibliography- Attinasi M. G., C. Checherita y C. Nickel (2009): “What Explainsthe Surge in Eurozone Sovereign Spreads during the Financial Crisisof 2007-09?”, ECB Working Paper no. 1131/2009.- Barro, R. J., N. G. Mankiw y X. Sala-i-Martin (1995): “CapitalMobility in Neoclassical Models of Growth”. The AmericanEconomic Review, 85(1), 103-115.58
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