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The Future of the Euro (Brown book 2012)

  1. 1. BROWN BOOK ANDRÉS DOMINGO AND DOMÉNECH VILARIÑO / XXVIII EDICIÓN DEL LIBRO MARRÓN The Future of the Euro DÍEZ GANGAS / DONGES / GARCÍA ANDRÉS / GROS Y ALCIDI / MARTÍNEZ RICO / REQUEIJO GONZÁLEZ / SÁNCHEZ FUENTES, HAUPTMEIER AND SCHUKNECHT / BROWN EDITION BOOK XXVIII The Future of the Euro El futuro del euro The Brown Book in 2012 meets his XXVIII edition. Year after year since 1984, this flagship publication of the Círculo de Empresarios has offe- red the most varied backgrounds a platform from which to contribute their ideas and proposals on economic policy that requires our country to its further development. The Brown Book contributes to one of the founding objectives of the Círculo as the center of the view that encourages and promotes debate on key issues for the benefit of Spanish society as a whole. JULIO 2012 CÍRCULO DE EMPRESARIOS C/ MARQUÉS DE VILLAMAGNA, 3, 10ª. 28001 MADRID TEL 915781472. FAX 915774871 www.circulodeempresarios.org July 2012
  2. 2. The Future of the Euro Brown Book Madrid, July 2012 EDITION SPONSORED BY
  3. 3. © 2012, Círculo de Empresarios C/ Marqués de Villamagna, 3, 28001 Madrid The partial or total reproduction of this publication, or its hand- ling by software, or its transmission under any circumstance or by any means, whether electronic, mechanical, by photocopies, recording or other means, without the express written consent of the copyright holders, is strictly forbidden. The articles reflect the opinions of the contributors, and not necessarily those held by Círculo de Empresarios. Legal deposit: M-24161-2012 Design of collection: Miryam Anllo m.anllo@telefonica.net Illustration: María José Ruiz Publishing: Loft Producción Gráfica C/ Martín Machío, 15-1º. 28002 Madrid (Spain) Printed by Atig, S.L. Parque Empresarial Neinor - Henares edificio 3 - nave 10 4
  4. 4. The Future of the Euro Index Prologue 7 1. The future of the Euro after the Great Recession 15 Javier Andrés and Rafael Domenech 2. Nature and Causes of the Euro crisis 63 José Carlos Díez 3. The European crisis and the challenge of efficient economic governance 97 Juergen B. Donges 4. The turbulent adolescence of the euro and its path to maturity 131 Gonzalo García Andrés 5. Breaking the common fate of banks and governments 197 Daniel Gros and Cinzia Alcidi 5
  5. 5. 6. The fiscal institution in the Economic and Monetary Union: the contribution of Spain 227 Ricardo Martínez Rico 7. The European Monetary Union: the Never-Ending Crisis 265 Jaime Requeijo 8. Public expenditure policies during the EMU period: Lessons for the future? 289 A. Jesús Sánchez Fuentes, Sebastian Hauptmeier and Ludger Schuknecht 6
  6. 6. Prologue The crisis in Spain is, to a large extent, the crisis of the Euro. On the one hand, the sustainability or otherwise of the monetary inte- gration project hinges on Spain, as the fourth economy in the Eurozone. On the other, Spain has no leeway available for fiscal sti- mulus packages, and the success of its adjustments required stabi- lity in the Eurozone. Hence, both crises are the two sides of the same token. The crisis faced by Euro economies and the adjustments made and which will be made in the most vulnerable ones, are coming at a high price which has not yielded tangible results to date. Círculo de Empresarios believes that the current situation calls for an impro- vement in European institutional architecture, in regard to greater integration and, above all, more commitment to reforms in Spain. The natural environment of our country is the Eurozone. Over the last few weeks, citizens are beginning to live with the different rescue modalities, as they had already done with the risk premiums. Financial aid for troubled economies is quite diverse in terms of implications, instrumentation, conditionality and scope of application, therefore requiring detailed analysis for determination. Although each carries its benefits and disadvantages, in the opi- 7
  7. 7. nion of Círculo de Empresarios, the greater scope and conditionality scenarios – known as country-rescue – are not a desirable option. This is why these must be avoided. Indeed, an intervention or rescue, of its own accord, without advancements made in the Eurozone architecture, shall not protect any of its members from future scares. Domestic adjustment may be less effective if no advancements are made in fiscal and banking union, and in the European capacity to provide asymmetrical res- ponses to national situations which are also different. The most vulnerable countries in the Eurozone must no longer be perceived as foreign currency debtors and it is imperative that the coordina- tion of economic policies of Member States is improved. Without such adjustments, a sustained growth path will not be possible to achieve. On the other hand, the crisis in Spain is the result of an accu- mulation of imbalances due to a series of inadequate signals and policies. Spain must face up to its responsibilities in terms of fiscal consolidation and structural reform. All in the interest of recove- ring competitiveness and encouraging a suitable environment to attract growth-contributing investments. In such circumstances, Círculo de Empresarios cannot help but take part in the debate on the future of the Euro. The XXVIII edi- tion of the Brown Book is dedicated to this matter and gathers a varied number of authors, all with broad experience in the issue 8
  8. 8. and proven academic and professional records. Therefore, this publication, with the sponsorship of BBVA as in previous years, maintains its nature as a publication which is open to different ideas and opinions, not necessarily shared by Círculo de Empresarios. As in previous editions, the articles appear in alphabetical order by the surnames of their authors, although these can be grouped into three broad categories: the crisis of the sovereign debt in Europe and the future of the Eurozone; the reform of economic governance and operations of the institutions in order to solve the sovereign debt crisis in Europe; and the integration into the Eurozone, the fiscal coordination mechanisms, Eurobonds and the assignment of sovereignty. In their paper, Javier Andrés and Rafael Doménech analyse the challenges faced by the Eurozone and the proposals to handle them by improving economic governance. To this end, they begin by reviewing the reasons underlying the accumulation of signifi- cant imbalances in developed economies and among EMU coun- tries, mainly from 2001 until the start of the crisis in 2007, as a result of an unsustainable growth pattern in many developed eco- nomies. Secondly, the magnitude and implications of such imba- lances and the heterogeneity between EMU countries are closely examined. Finally, the authors analyse the challenges involved in the improvement of economic governance of the EMU on the fis- cal, financial and economic integration fronts, which will determi- ne its short and long term economic future. 9
  9. 9. José Carlos Díez analyses the Euro crisis. He reviews the histori- cal background of the European and single currency projects, and the theory of exchange rates to provide conceptual support to ena- ble an understanding of the nature and the causes of the crisis. According to him, this is an infrequent, but highly destructive, dise- ase found in economics, especially in developed countries, since it causes devastating damage to the employment and public debt of the affected countries. For this reason, he believes it is essential to come up with the correct diagnosis in order to define the economic policy that will put an end to the crisis. The main causes analysed are financial integration, the under-assessment of risk, local imba- lances within the Eurozone and the Great Recession. The aim of Juergen B. Donges is to bring the current debate on the need for economic governance in the European Union, and par- ticularly in the Eurozone, into the context of political realities. He analyses the issue of governance from a historical and current pers- pective, and highlights the significant fact that the Eurozone does not constitute an optimal monetary area. He then moves on to analyse the forms of governance to date and considers new approa- ches to European governance. Finally, he ends his analysis with a tone of moderate expectation. If the Governments of the Euro countries understand that the solidity of public finances and the application of struc- tural reforms are their responsibility and act in accordance, no State must rush to the aid of another due to over-indebtedness and overspending, and the ECB may stop indirectly funding the States and focus on its own duty, which is to ensure the stability of the price levels within the Eurozone. 10
  10. 10. Gonzalo García Andrés highlights that, despite having taken decisive steps in national policies and institutional framework reform, the Euro crisis has worsened to the point of calling its sur- vival into question; and no definitive solution is yet on the hori- zon. In his article he attempts to offer an interpretation of what has happened, assuming the extreme complexity both of the starting point (with accumulated imbalances and structural deficiencies in several countries), as of the outbreak, the contagion and the esca- lation of the crisis. And he does so in the broader context of the global financial crisis, which has affected economic and financial development for five years, in order to determine which specific aspects of the Euro have played a key role. All this with a view to encouraging a reflection on solutions, bringing together the most urgent and the ones with a longer term effect. Cinzia Alcidi and Daniel Gros point out that the Eurozone cri- sis encompasses different dimensions, from foreign debt and current account balance problems, to the weak situation of the ban- king sector. The document focuses on this last issue, the situation of the banking system, and attempts to show the way in which current characteristics of the regulatory framework of the financial market have influenced the development of the crisis. In addition, they express their concern about the false idea that the recently sig- ned fiscal convention shall become the fundamental ingredient of the recipe to overcome the crisis, when the banking sector conti- nues to be heavily indebted and exposed to the vicissitudes of sove- reign States. For this reason, they present a few ideas to break the 11
  11. 11. close ties between governments and banks, since these links them in a common fate and constitute a clear impediment to recovery from the crisis in the Eurozone. Ricardo Martínez Rico, throughout his work, analyses the way in which the sustainability of public finances requires a sold fiscal institution and a firm political commitment by European govern- ments. Subsequently, he tackles the close relationship between fis- cal rigour, macroeconomic stability and growth, concluding that, in order to achieve a positive inter-relation, the establishment of fiscal rules which are simple, transparent, automatically applied and with preventive control mechanisms for all Public Administrations, is essential. All these items are key when designing a fiscal policy which contributes to recovering the credibility required by Europe along its route towards greater integration to handle the sovereign debt crisis. Lastly, he examines the measures taken in Europe and Spain since the start of the sovereign debt crisis, and reflects on the next steps that should be taken towards a fiscal institution. The work of Jaime Requeijo aims to provide a reasoned expla- nation of the causes of the financial shocks affecting several Eurozone countries, and which endanger the survival of the single currency (the Monetary Union is a poorly built structure because political urgency has prevailed over economic prudence; the fiscal irresponsibility of many member state governments has translated into the appearance of large public debt; such debts generate doubts as to their holders; and, contributing factors such as the 12
  12. 12. effects of contagion or of the opinions of the rating agencies and IMF predictions). In the article he also attempts to reply to three questions on the measures taken, the results thereof, and the impact of a potential decomposition of the euro. The article ends with a brief final reflection on the solution to be applied in order to maintain the Monetary Union. A. Jesús Sánchez-Fuentes, Sebastian Hauptmeier and Ludger Schuknecht state in their article that an ambitious fiscal reform within a broader programme of reforms would have highly positi- ve effects insofar as it would provide for a safer fiscal position, in line with the requirements of the Stability and Growth Pact (SGP). Expenditure control policies must therefore go hand in hand with structural reforms, mainly focused on reducing rigidity in the labour and product markets, on the correction of macroeconomic imbalances, on the improvement of competitiveness and on sus- taining potential growth. This becomes particularly key for the most vulnerable countries in the Eurozone, which no longer have the option of currency devaluation to increase competitiveness. Finally, and on behalf of Círculo de Empresarios, I wish to thank all the authors for their contributions to this new edition of the Brown Book and I trust that these articles help to shed light on a solution to the European trilemma. Mónica de Oriol President of Círculo de Empresarios 13
  13. 13. /JAVIER ANDRES * / RAFAEL DOMENECH**/ The future of the Euro after the Great Recession 1 Summary; 1. Introduction; 2. From the Great Moderation to the Great Recession; 3. The imbalances in Europe and in the EMU; 4. The new European governance and the future of the Euro; 4.1. Changes in fiscal governance; 4.2. Financial integration; 4.3. Economic integration; 5. Conclusions. Summary In this chapter we shall analyse the challenges the Eurozone is facing and proposals to deal with them via improved economic governance. To do so, * Javier Andrés is professor of Fundamentals of Economic Analysis at the University of Valencia and visiting professor of the University of Glasgow. http://iei.uv.es/javierandres/ ** Rafael Doménech is Chief Economist of Developed Economies, BBVA Research and Professor of Fundamentals of Economic Analysis at the University of Valencia. http://iei.uv.es/rdomenec 1 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
  14. 14. The future of the Euro after the Great Recession we shall first examine the reasons behind the accumulation of significant imbalances 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 an in-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 the EMU from a fiscal, financial and economic integration perspective, which shall determine its economic future in the short and long term. 1. Introduction The international economic crisis which begun in 2007 is having an extraordinary impact on the European economy, and for the 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 the Economic and Monetary Union (EMU) in 1999, had entered into an unsustainable dynamics in the long term. The appearance of important macroeconomic imbalances among EMU members was taking shape within the framework of steady growth, inflation under control, very low interest rates and a very reduced risk assess- ment (partly as a result of the disappearance of currency risk) in the context of a world saving glut. Although the Eurozone as a whole presents smaller aggregate imbalances in terms of deficit and pri- vate, public and foreign debt than, for instance, the US or the United Kingdom, the expectations of economic convergence 16
  15. 15. The Future of the Euro among Eurozone countries and the appearance of financial bubbles with the promise of high yields, led to very significant capital flows among 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 current account balances. These expectations petered out sharply as of the subprime 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 off each other over time.2 The result of this complex situation has been that, albeit with differences in the intensity and the severity of the problems (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 by some emerging economies, leaving public and private sectors heavily indebted and, in some cases, extremely high rates of unemployment. The aim of this chapter is to analyse the changes required by the EMU 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 Great Moderation), which nevertheless gave way to an unsustainable 2 Shambaugh (2012) performs an excellent analysis of the interaction between fiscal, financial and economic crises in the Eurozone. 17
  16. 16. The future of the Euro after the Great Recession growth pattern in many economies. In the third section, we offer an in-depth analysis of the magnitude and implications of such imbalances throughout the crisis, which are well summarised in the Excessive Imbalance Procedure (EIP) recently implemented by the EU, as well as the current heterogeneity among EMU countries. The fourth section analyses the challenges of improvement of economic governance of the EMU from a fiscal, financial and economic inte- gration standpoint, which shall determine its short and long term economic 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 growth rates in those years. Graph 1 shows evidence of this for the US and the EMU in terms of GDP per person of employable age. As can be seen, from the mid-1990s to 2007 there was sustained growth, with levels well above the historical trend estimated since 1970 for both geographical areas. In fact, the growth in GSP per person of emplo- yable age was slightly higher in the EMU than in the US, although not enough to bridge the gap between both economies. The Great Moderation generated the perception that economic cycles would have less volatility, as a result of better managed eco- 18
  17. 17. The Future of the Euro nomic policy (see, for instance, Galí and Gambeti, 2009, or the references appearing in this article). In fact, these high growth rates with low volatility came hand in hand with inflation under con- trol and low interest rates across the board of financial assets, with practically inexistent risk premiums in many cases as a result of the underassessment of the risk. In light thereof, some analysts went as far as to proclaim the disappearance of the economic cycle and the capacity 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), among others, 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. In the first place, the central banks of the developed economies carried out a low interest rate policy or money glut, as a result of: i) the drop in the inflation of sellable assets following the inrush of exporting countries in the international economy with a very abundant and cheap workforce and depreciated currencies; ii) the benign neglect policy in regard to the high prices of financial and real estate assets (Bordo & Jeane, 2002, or Bean 2004 & 2010); and iii) the attempt to prevent 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 in China, Japan, Germany, oil producing countries or the pension 19
  18. 18. The future of the Euro after the Great Recession funds of developed economies. Thirdly, and as a response the savings glut in some countries and sectors, a formidable increase took place in the demand of safe assets, moving from the pre-eminence of individual savers to that of large sovereign funds, investment funds or pension funds which prioritize safety over yield and which seek to channel savings towards fixed income rather than towards the acquisition of any other kind of asset. At the same time that the demand for safe financial assets (i.e. AAA) increased, there was a relative scarcity of such 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
  19. 19. The Future of the Euro dation taking place simultaneous in many developed economies as a result of the high growth in GDP. This surplus demand for safe assets created enormous pressure in the financial markets and in certain 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 the response of the financial markets to this scarcity in AAA assets to be the creation of multiple derivatives and the issue of huge volu- mes of asset backed securities, as shown in Graph 2. In turn, this generated enormous liquidity to fund those assets acting as the underlying assets (for example, mortgages on homes), thus crea- Chart 2 Issue of Asset backed Securities 1985-2011 Source: SIFMA 21
  20. 20. The future of the Euro after the Great Recession ting a circle in which asset demand stimulated supply, which in turn was fed back into the process by boosting demand with the creation of new assets. As a result of this process, a specialization in asset production took place on an international level, leading to enormous hetero- geneity by country, sector and agents. Whereas some countries generated a surplus in net savings, others (US, Spain or Ireland) res- ponded to the very low interest rate incentive by generating the real investments which served as the underlying assets for finan- cial securities. The US produced assets on a world scale considered safe by the markets, thanks to the specialization of its financial ser- vices. Other countries, such as Spain and Ireland, carried out a similar role, but on a European scale, producing assets backed by safe collateral (homes) or with no collateral, but issued by financial institutions deemed to be safe, which attracted savings funds or large 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, as well as in the EMU countries, expectations that the greater monetary and economic integration ensured the economic convergence of its members were generated, which justified the disappearance of any type of risk premiums (see Ehrmann et al, 2011). 22
  21. 21. 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 convergence were 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 natural that capital should flow towards the economies with lower per capi- 23
  22. 22. The future of the Euro after the Great Recession ta incomes, as economic theory predicts (see, for example, Barro, Mankiw & Sala-i-Martin, 1995). In fact, as the risk premiums were disappearing, the correlation between the savings rated and investment rate were reduced. As was already anticipated by Blanchard and Giavazzi (2002), since 1999 to the start of the crisis, the Feldstein-Horioka paradox disap- peared completely, as shown in Graph 4. Coinciding with the reduction 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: Bloomberg 24
  23. 23. The Future of the Euro almost zero as of 1998, the correlation between the national invest- ment rate and the savings rate was observed to have been nil or even negative, compared to the positive and statistically significant values of the beginning of the nineties. In fifth place, a permissive regulation, together with reduced interest rates and very high competition in the financial sector generated the incentives required for the generation of profit to be done via transaction volume instead of via price margins (mainly interest rates), favouring a very important leveraging of broad seg- ments of the private sector. One of the results of this process was the intensification of a new banking business model, based on the granting of collateral backed loans, the generation of financial assets from such loans and the distribution thereof as asset-backed securities in asset packages (originate to distribute) which transfe- rred credit risk in full to the purchasers of these new generated assets. Compared with the traditional bank business, in which financial institutions that grant the credits keep the risk on their balance sheets, this new business model led to greater intercon- nection of the balance sheets among financial institutions all over the 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
  24. 24. The future of the Euro after the Great Recession mic stability and inflation, during which enormous imbalances of a financial and competitive nature have been created. However, a glance of the macroeconomic picture of the EMU reflects a situation of balance which we do not find in other important economic regions of the world (Table 1). Both the deficit and public debt levels and the net foreign positions and private indebtedness are generally lower to those recorded in the United States or the United Kingdom. However, the EMU has had other problems hanging over it which have led the economy of the region – and that of the whole of the EU by extension – to the situation of stagnation which it is currently undergoing. Some of these problems are of a structural nature, and others are related to the extraordinary disparities between member states in their key indicators to which, until very recently, we had paid little attention. Among the first are demographic evolution and low productivity growth which in turn have provoked a limited rate of growth in employment. But the disparities and the heterogeneity within the EMU are the most outstanding imbalances, as they call for a serious amendment in the operation of the Euro, whose main objective 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 track macroeconomic and financial imbalances in countries within the EU (the EIP). One of these indicators summarises, over all others, the nature of the main problem facing the European economy: 26
  25. 25. The Future of the Euro the gradual and persistent disparity in the current account of its member countries. Although the EMU and the EU are economies which can be described as economies which contribute (and demand) little net savings to (and from) foreign savings, their aggregate results is the sum of extremely disparate realities. As Lane (2010) points out, in 2010 European countries accounted for approximately one third of all current account deficits and sur- pluses worldwide. As can be seen in Graph 5, the current account deficits and surpluses of the EMU have gradually polarised from levels ranging between the [-3%-, +3%] interval, in proportion to the GDP to position itself outside of this range and even persis- tently above it by 5%. The underlying causes and macroeconomic implications 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
  26. 26. The future of the Euro after the Great Recession It is true that this polarisation is not an exclusively European phenomenon, as it happens in parallel with the so-called “global imbalances” 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) and emerging 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 the less developed. This has rendered such imbalances less conspicuous, as they have been associated with the real convergence process. The traditional view considered foreign indebtedness as a natural con- sequence of the catching up process during which the countries undergoing rapid growth required foreign savings to fund strong domestic investment in commercial goods. Thus, the availability of savings and the Euro allowed for the funding of the productivity convergence 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 for public political intervention – what became known as “benign neglect” by Blanchard and Giavazzi (2002) or Edwards (2002). It is not easy to determine an optimal level, or even an adequate one, for the current account deficit which already reflects the gap between domestic savings and investment in a country which is assumed to have been optimally determined by consumers and busi- nesses, unless it is associated with high public deficit, in which case we would be dealing with a fiscal problem. Moreover, a country may 28
  27. 27. The Future of the Euro have a deficit current account without having a serious foreign financing problem, or may have it despite having a regularised account, in this case because despite a reduced net capital flow, what matters in the event of a financial crisis is the size of the gross flows, as nothing guarantees that national savers are willing to fund domestic 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 adjustment role of the market mechanism has proven insufficient and in which gross 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
  28. 28. 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 certain extent, Ireland, which accumulated growing deficits despite the slow growth of total productivity of the factors. As can be seen in Graph 6, productivity grew by 1% on average, whereas the current account balance varied between surpluses over 5% (the Netherlands and Germany) and deficits of 10% (as in Portugal and Spain). In fact, it has not only been the lure of investment but mainly the fall in savings in peripheral countries which has caused the gap in commercial deficit which has exceeded both in volume – percentage of GDP – and in persistence, that observed in many emerging countries prior to the crisis of the eighties and nineties. Moreover, much of the foreign financing to the receiving countries has not been channelled through direct and portfolio investment, but by way of bank bonds, which increases the risk of bank crises and ‘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. Far from being a transitory phenomenon, the divergence between commercial balances has sharpened until 2007 (see Graph 5). The design of the Euro took into account that the absence of own currency would hinder the traditional adjustment to which most countries resorted in times of crisis in the balance of payments. The impossibility of this recourse to devaluation has not come hand in hand with the strengthening of real devaluation mecha- 30
  29. 29. The Future of the Euro nisms, that is, with a more flexible response by prices and salaries. Between 2000 and 2010, enough time has lapsed to have expected that the countries with most foreign debt and strong real apprecia- tions should have begun a process of correction towards a surplus in the commercial balance. Nevertheless, this has not been the case. The correlation between the commercial deficit and the net foreign position was positive in 2011 and in 2010 (Graph 7) as it had been in the last decade, indicating that the private savings/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
  30. 30. 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 only Finland had managed it after correcting a very negative position in 2001 (that is, after a decade of foreign rapid growth and surplus). Practically all other EMU countries saw their net indebtedness increase substantially or, at best, such as in France or Austria, they managed a moderate reduction thereof within the first ten years of the single currency. Therefore, the performance of the current account is a very use- ful indicator – although naturally not infallible – of the way in which a country responds to the commercial and financial globa- lisation process and to the existence of other types of imbalances associated with private sector debt, both financial and non-finan- cial. Before reviewing these indicators for the EMU (EU), it is worth asking why the (market) adjustment mechanisms have failed in this case and what the risk of this situation is happening again in the future. The conventional current account approach indicates that financial flows are a mere counterpart of commercial flows, so that sustainability of foreign debt must be guaranteed by the expecta- tion of future current account surpluses or, what is the same, by a significant proportion of the commercial goods production in the economy. Foreign financing is no at risk while foreign investors consider the economy to be competitive. The domestic economy must maintain a high productivity growth rate and competitive 32
  31. 31. The Future of the Euro labour costs, as the opposite would render the foreign deficit unsustainable, foreign investment would drop, reducing prices and salaries and improving the foreign balance. In this way, given rea- sonable elasticity in the demand of exports and imports, the periods of real appreciation and foreign deficit can be reversed wit- hout deep structural changes. However, this market mechanism has not worked in peripheral Europe. 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
  32. 32. The future of the Euro after the Great Recession non-commercial goods, leading to strong expansion of demand, of prices and of labour costs (see Graph 8). Despite the loss of com- petitive capacity, the appeal for foreign lenders continues provided the value of the asset with real guarantees – such as homes – con- tinues, which is perceived as relatively safe. Thus, the worsening competitiveness 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 a smooth and orderly manner. When the bubble bursts and prices of the assets used as guarantees plummet, foreign investors perceive that the national economy is no longer able to guarantee their debt, 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 go beyond the control of deficit and debt, and to follow a number of economic indicators which enable the detection of inadequate macroeconomic 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 a country, 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, if not suitably applied, might result in some form of political or eco- nomic penalty. The list of indicators is the following (the limits 34
  33. 33. The Future of the Euro above which a form of relevant imbalance is detected appear in brackets): 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%); and unemployment rate (10%). Chart 8 Growth of nominal salaries and real productivity Source: BBVA Research based on Eurostat 35
  34. 34. 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 have 3 The situation is worse if we take into account that indicators such as the growth rate of 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 EU economies. 36
  35. 35. The Future of the Euro become evident following the segmentation of the financial mar- kets due to the crisis. On the one hand, we have the demographic and structural characteristics of most of the countries, which herald for the future a scenario of lesser growth than that before the 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 United Kingdom, Japan, and the US. The aging population and its effects on participation in the labour market, the low savings rates – with the ensuing difficulties in funding investments – and the slow rate of productivity growth explain 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 an additional burden on public finances by way of contingent liabili- ties, the realisation of which shall depend on the performance of the private debt and the need to apply measures to assist in the reconversion of the financial sector. As stated by Reinhart & Rogoff (2008 and 2009), one of the main consequences of financial crises is that a large part of the private sector debt becomes public. Table 3 (ECB, 2012) shows the impact on public finances of the two main contingent-type averages within the EMU: provisions for the European Financial Stability Facility (EFSF) and the guarantees for the banking sector. The sum of both would mean an additional impact 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
  36. 36. 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
  37. 37. The Future of the Euro rialise, but it is also true that provisions have proven insufficient and 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 generation of implicit liabilities which are not considered in public debt figu- res but should be taken into consideration when evaluating the sustainability of public finances (Cecchetti, Mohanty and Zampolli, 2010). In 2009 the IMF (IMF, 2009) calculated the sum of implicit and contingent liabilities in securities exceed – in present value – 400% of the average GDP of the G20. Of these, those of a contingent nature associated with the crisis account for approxi- 39
  38. 38. The future of the Euro after the Great Recession mately one tenth, whereas that associated with an aging popula- tion – pensions and social security – account for much higher implicit obligations. As a whole, this type of liability will demand a remarkable effort from public finances in the future. Cecchetti, Mohanty and Zampolli (2010) place the additional permanent financing required to meet such obligations at between 5 and 10 GDP points assuming a public debt at levels similar to the current ones in developed countries. In summary, some European economies may have reached debt levels which exceed or are dangerously close to their fiscal limits, defined as the maximum level of debt which a country is able to fund. The fiscal limit depends on the political will of its citizens and the capacity to increase income by means of tax rate rises (Bi, 2012 and Leeper & Walker 2011) which makes it specific to each country. This might explain, at least in part, the differences obser- ved in risk premiums between countries with similar levels of debt or even that some countries pay a higher cost of financing that others with much higher levels of debt. Moreover, the relationship between the risk premium and the fiscal limit is non-linear, incre- asing rapidly when fiscal performance places debt at such levels that the likelihood of reaching the limit is significant (Bi, 2012). That is to say, in order to observe significant risk premiums, it is enough for investors to understand that the fiscal strategy of a country leads it to a fair likelihood of reaching the maximum level of debt financed, even if the probability of this taking place in the short term is very small. This probability in turn grows over the 40
  39. 39. The Future of the Euro economic cycle, which obliges countries with greater volatility in economic activity and unemployment to opt for stricter fiscal rules.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: BCE 4 When the economies reach this limit, the efficacy of the fiscal and monetary policy is substantially reduced and both instruments no longer have the expected effects on economic activity. The fiscal multipliers are reduced and the monetary authority loses the capacity to control inflation, irrespective of the aggressiveness of its monetary policy. 41
  40. 40. The future of the Euro after the Great Recession 4. The new European governance and the future of the Euro The economic crisis has highlighted the need to carry out important changes in European governance. It is obvious that there have been failures in coordination in the economic policy and 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 the supranational institutions and bodies to prevent the crisis and to provide 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 important inroads have been made, among which are the Stability, Coordination and Governance Treaty and the creation of the European Stability Mechanism (ESM). The new Treaty, which shall come into force on 1 January 2013, has been signed by all EU coun- tries except for the United Kingdom and the Czech Republic, and aims to make public finances sustainable and prevent the onset of excessive public deficits, in order to safeguard the stability of the Eurozone as a whole. In fact, this Treaty can be interpreted as a second version of the Maastricht Treaty of 1992, with the differen- 42
  41. 41. The Future of the Euro ce that whereas the former determined the conditions to enter the EMU, the new treaty can be said to detail the conditions to be met by 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 determined by the European Commission, and a public debt below 60% of GDP) and automatic mechanisms which enable the adoption of corrective 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 it allows for the influence of automatic stabilisers, the minimum being between 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 mechanisms proposed by the European Commission must be rejected by a majo- rity, whereas in the SGP the majority needed to be reached in order to approve such proposals. It is also the experience of the current debt crisis has led to an accumulation of collective knowledge which shall prove very useful when adopting the right decisions in the future to prevent new crises of this kind. Just as eighty years later the Federal Reserve is currently preventing some of the well-known mistakes which were made during the Great Depression of the 1930s, the European Commission and the European Council shall endeavour to prevent imbalances similar to those we are currently undergoing. 43
  42. 42. 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 this paper), indicates that use of fiscal rules has proven useful in the containment 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 rules like those included in the Stability Treaty do not have to be an impediment for the fiscal policy to carry out its duty of stabilisa- tion of economic cycles. Quite the opposite: when the economic agents know, that as a consequence of the existence of such rules, expansive fiscal policies in the short term shall be offset in the medium term by counter-adjustment measures in order to prevent the accumulation of public debt, the effectiveness of these discre- tionary stabilisation policies increases, as has been proven by Corsetti, Meier and Müller (2011). In any event, it shall be very difficult to achieve an optimal implementation of the Treaty. In the first place, because all govern- ments are often too complacent when allocating probabilities to possible risk scenarios which may render public finances unsustai- nable. Secondly, because it is difficult that sanctions may come about 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 of public income and expenses to this cyclical position. Nevertheless, what the Stability Treaty does provide is that, prior to reaching sanctions, the Commission may exert much greater pressure on 44
  43. 43. The Future of the Euro national governments and alert markets about excessive imbalan- ces, so that it is the markets themselves that impose discipline via higher interest rates. As for the ESM, at the ECOFIN on 30 March the decision was taken to extend it to 500 thousand million euros, which shall be provided over two years, and beginning on 1 July 2012. The extent to which this fund will be sufficient is still unknown, in that it shall depend on how it is used and whether it allows for fund leve- raging. Without leveraging, the fund shall only be enough to cover the financing needs of small or medium sized economies in the EMU, but not of the big four. However, it may prove effective for specific, selective but highly intensive interventions designed to reduce risk premiums, that is, to replace the ECB in its Securities Market Programme (SMP). In addition, if the ESM should obtain liquidity from the ECB itself, each of these entities might be able to separately specialise in the management of a risk: the SMP would manage the ‘solvency risk’ of sovereign debt and the ECB would managed the ‘liquidity risk’, thus enabling the central bank to resu- me the natural role for which it was created, as it would be creating an 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 about which countries are solvent, with adoption of any necessary adjust- ment measures and structural reforms, and which countries need 45
  44. 44. The future of the Euro after the Great Recession some kind of debt restructuring. In the first case, which is clearly applicable to countries such as Spain and Italy, SMP intervention on risk premiums should be as intense as necessary until market doubt and uncertainty have been obliterated. It would otherwise be very difficult to convince sovereign, pension or investment funds to purchase the public debt of such countries if Europe is not the first to refrain from doing so. Obviously, a more decisive intervention by the SMP, which would lead to a rapid relaxation of the European sovereign debt markets, requires the adoption and follow-up of the necessary adjustments and reforms, but with sufficient time frame so as not to asphyxiate the economic growth of the countries adopting such policies. Specifically, the EU could change the fiscal consolidation strategy which is currently being demanded from member states. The obsession for nominal deficit targets should be replaced by a more 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 public finances of all countries. Specifically, the European consolidation strategy 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 the 46
  45. 45. 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 to prudent levels of public debt, it would be advisable to apply the pro- verb of “slow and steady wins the race”. A similar recommendation to that of De Long and Summers (2012), for whom a fiscal consolidation which 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 necessary or sufficient, these can indeed become a useful tool in the con- text of streamlined national finances. They are not necessary, as the Eurozone can operate without them, if the Stability Treaty and the mechanism for the prevention and correction of excessi- 47
  46. 46. 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 their 5 Attinasi, Checherita and Nickel (2009) believe that this market discipline is behind the increase in sovereign spreads between 2007 and 2009, as a result of the increase in risk aversion and the concern for the sustainability of public finances. However, Favero and Misale (2012) believe that this market discipline acts in an interrupted fashion over time and, occasionally, in an exaggerated way, which in fact justifies the issue of euro- bonds. 48
  47. 47. The Future of the Euro public debt up to 60% of their GDP as senior debt under the joint and several responsibility of all members, whereas the issue of national debt beyond such a limit would be junior debt under indi- vidual responsibility. From this perspective, it is easy to conclude that the decision of the European Council reached in December 2010 to ensure the solvency of the debt issued until June 2013, but not that issued as of that date was a mistake, as the decision should have been the opposite: ensure as of a given date all debt issued under 60%, which would in effective terms be equal to the creation of the Eurobonds proposed by Delpla and von Weizsäcker (2010). 4.2. Financial integration As Pisany-Ferri and Sapir (2010) have pointed out, to date the EMU has worked without a European institution able to rescue transnational financial entities and without authentic European stress tests for its banking institutions. Oversight duties have remained with national authorities and coordination problems have been managed by means of a combination of discretionary cooperation and dependence on rules approved by the EU. One of the lessons to be learned from the current crisis is that it 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 Europe in terms of crisis management and resolution is precisely due to the non-existence or the delay in creating such bodies. The US has 49
  48. 48. The future of the Euro after the Great Recession federal institutions to manage banking crises, whereas Europe does not, which renders true the saying that banks are internatio- nal when expanding and national upon demise. The problem is that, 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 has enormous national dispersion of its regulations, despite the efforts 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 to other rules continuing to be different. This was the case, for ins- tance, of the requirement of the European Banking Authority that potentially systemic banks must exceed a capital ratio of 9% before 30 June 2012, when the measurement of risk weighted assets is regulated by different rules. Banking oversight in Europe is furthermore carried out via national supervisors instead of via a single European institution, which introduces heterogeneity in oversight levels of the financial system. The result of this financial fragmentation is that one can- not speak of a single market, which generates the possibility of regulatory arbitrage, different conditions of competency, ineffi- ciencies and, in general, a disadvantage in regard to other world financial areas. 50
  49. 49. The Future of the Euro In summary, financial integration requires an improvement to be made in the mechanisms through which information is shared on the financial systems of each country and the way in which their activities are supervised, the harmonisation of the guarantees on bank deposits and of consumer protection regulations, the creation of European bank restructuring and rescue mechanisms, and the advancement towards a Single Market not with more, but with a bet- ter, European regulation which, instead of adding to and prevailing over national legislation, should simplify and replace it. 4.3. Economic integration With greater fiscal and financial integration the Eurozone could operate with less tension in the future, without ensuring the economic convergence among countries. Is convergence of income or welfare levels in European countries necessary? Probably not, but it is still con- venient, as has been stated earlier, to enable societies to believe that being within an economic and monetary union has advantages well beyond those which are provided by monetary stability. One of les- sons to be learned from the Eurozone crisis is precisely that monetary integration does not ensure economic convergence, as this requires an advancement in convergence of the determining factors (economic, social and institutional) of economic growth. Table 4 shows that the differences in medium and long term determinants of per capita income are very significant. The relati- ve position of each country has been obtained on the basis of the 51
  50. 50. The future of the Euro after the Great Recession IMF analysis (2010), whereas the allocation of each country to one of three groups under consideration has been carried out on the basis of the criteria put forward by Hall and Soskice (2001). On the basis of a number of criteria, both institutional and based on the workings 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 are the paradigm). In both models (either with high or minimum coordination), the economies can function efficiently. Market eco- nomies which cannot be classified into either group are classified as 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 levels considered by the IMF, where a higher score suggests a greater need for implementing structural reforms. This enables the obtention of an average for each country and for each of the nine indicators which are shown in Table 4. The differences shown in this table are very marked, not only between developed economies, but also bet- ween European ones. In light of this evidence it is not surprising that, except in the case of Ireland, the countries which have accu- mulated the most imbalances and which are suffering more form the tensions in the debt market are precisely those which shown greater structural weaknesses and the ones which must implement the most reforms. Countries which in turn have been classified as mixed market economies, presenting more inefficient institutions. 52
  51. 51. 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
  52. 52. The future of the Euro after the Great Recession The changes in the regulations which affect the operation of the labour, goods and services markets, trade, telecommunications markets, are easier to implement in the short term, although the changes thereof are felt in the medium term. An example of this can be found in the recent reform of the labour market in Spain, which is bringing its operation in line with that of countries like Germany (in terms of internal flexibility mechanisms) or to that of free market economies (by prioritising company agreements and opt out clauses for collective bargaining agreements). Making headway in these types of reforms (for example, linking salaries to productivity) is crucial to remove the differences in competitive- ness which exist between EMU countries, particularly bearing in mind that the crisis may have had an effect on the potential growth of these economies (see, for example, the European Commission analysis, 2009). However, in long term indicators such changes can take a lot longer and, in some cases, even decades. This is the case with human capital. Even in the event that the many younger workers of countries such as Spain, Italy, Greece or Portugal should enter into the labour market with the same human capital as in better placed countries, 25 years would be needed to half the distance for the whole of the population of employable age. 54
  53. 53. The Future of the Euro 5.Conclusions The economic crisis has highlighted the excessive complacency of the markets, agents, supranational institutions and governments when interpreting the imbalances which were being generated in the previous expansion period and the absence of supranational institutions and mechanisms, firstly to prevent the imbalances which led to the crisis and secondly, to provide a fast and efficient response once they had happened. Such institutions and mecha- nisms are necessary because the evidence shows that the markets react in a discontinuous way, and occasionally in an exaggerated way, are pro-cyclical and do not generate of their own accord suf- ficient disciplinary mechanisms in the short and medium term whenever these are needed. Insofar as the current Eurozone crisis has taken place mainly in three areas (debt crisis, banking crisis and crisis in growth and competitiveness, with huge heterogeneity between countries), the EU and, particularly the EMU, need to improve 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 of Stability, Coordination and Governance needs to be effectively applies in a preventive way and that, during its transition towards medium and long term structural deficit targets, this is done with sufficient rigor and the right flexibility to prevent that countries required to make the most efforts in the short term should enter into a negative growth spiral. In this regard, intervention by the 55
  54. 54. The future of the Euro after the Great Recession ESM on risk premiums should be as intense as necessary until market doubts and uncertainty have been removed, so that the countries which are implementing fiscal adjustments and structu- ral reforms have a sufficiently broad time period to enable such measures to have positive effects on economic growth. As for the Eurobonds, although they are not necessary or sufficient to ensu- re the operation of the EMU, they are indeed convenient as an efficient mechanism providing assurance and pooling risk in the face 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 become an essential part of the future European Treasury when the main imbalances are well under way to being corrected through the decisive application of the reforms in the various countries in the EU. The second area where headway must be made is that of finan- cial integration, in order to prevent future banking crises and to manage them in a more efficient and rapid way. Europe must have supranational financial institutions, regulators and supervisors, as the current financial fragmentation prevents us from speaking of a single market. An important limitation which gives rise the regu- latory arbitrage, different competency conditions, inefficiencies and, in general, a disadvantage in regard to other world financial areas competing against the European entities. 56
  55. 55. 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 benefits which go beyond those provided by economic stability. The diffe- rences between the EMU countries in the workings of factor, goods and services markets are very significant, as well as in long term growth determinants. The structural reforms undertaken to enable the markets to work more efficiently can bring positive effects in a relatively reasonable period of time, enabling competitiveness to improve and the imbalances accumulated during the expansion and the crisis to disappear more rapidly. In this regard, it is essen- tial to ensure the success of the Excessive Imbalances Procedure and other imbalance monitoring mechanisms, ensuring a more efficient preventive and corrective action than that provided by the Stability and Growth Pact. However, in terms of long term growth determinants, such changes can take longer and, in some cases, even decades; it shall therefore be necessary for Europe to boost the solidarity mechanisms required to accelerate this conver- gence process in a more effective and efficient way than that done in the past. To simultaneous progress on all these fronts, both at suprana- tional and national levels, is a necessary condition for the Euro to overcome this crisis and for its members to continue to form part of this project in the future. Insofar as the starting point is very 57
  56. 56. The future of the Euro after the Great Recession different in each country, the main challenge now facing the EMU is to combine in a fair way the rigor and the ambition of the adjustments and structural reforms, on the one hand, with an appropriate time frame and solidarity with all other members of the Eurozone, on the other. If, on the contrary, the member states should fail to show such determination, any attempt towards European economic gover- nance will be due more an intention than a hard reality. The Eurozone would have an uncertain future. The alternative of a Political European Union, in which all necessary economic policies could be implemented from a community Executive under the control of a European Parliament and with all democratic rights, is currently not expected for the time being. Bibliography - Attinasi M. G., C. Checherita y C. Nickel (2009): “What Explains the Surge in Eurozone Sovereign Spreads during the Financial Crisis of 2007-09?”, ECB Working Paper no. 1131/2009. - Barro, R. J., N. G. Mankiw y X. Sala-i-Martin (1995): “Capital Mobility in Neoclassical Models of Growth”. The American Economic Review, 85(1), 103-115. 58
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  61. 61. /JOSÉ CARLOS DÍEZ * / Nature and Causes of the Euro crisis Summary; 1. Introduction; 2. Historical background of the Euro; 3. Nature of the Euro crisis; 4. Fixed versus flexible exchange rates: a review; 5. Causes of the Euro Crisis; 6. Conclusions; Bibliography Summary This work analyses the Euro crisis. It includes a review of its his- torical background and the exchange rate theory to provide con- ceptual arguments to help understand the nature and causes the- reof. It is an infrequent pathology in economics, particularly in developed countries, but with an enormous destructive capacity. * José Carlos Díez is an economist who has combined his academic and corporate roles throughout his professional career. His academic activity is linked to the University of Alcalá, where he was an undergraduate and PhD student and now is Professor of Fundamentals of Economic Analysis. He is currently the Chief Economist at Intermoney, a company founded in 1979 and leader in Spain in money market brokerage. He contributes with his forecasts to the panel of experts of the ECB on European economy and the panel of FUNCAS on the Spanish economy, and advises companies, financial entities and institutions both natio- nal and international. 63
  62. 62. Nature and Causes of the Euro crisis For this reason, it is important to get the right diagnosis when defi- ning the economic policy that will solve the crisis. The main cau- ses analysed herein are financial integration, the under-assessment of risks, local imbalances within the Eurozone and the Great Recession. 1. Introduction The world financial crisis, whose first symptom was the collap- se of the subprime asset-backed securities market at the start of 2007, has been changing. It is currently focused on Europe, and is calling into question the future viability of the Euro and the European project itself. This work aims to classify the nature of the Euro Crisis and to identify the main causes thereof. Although the objective is not to analyse potential economic measures designed to solve the crisis, without an accurate diagnosis of the origin and dynamics of the crisis, finding the right solution would be an exer- cise in chance. To this end, section 2 includes the history of the European pro- ject and the single currency. Section 3 describes the nature of the crisis, which is a seldom seen pathology in economics but which causes devastating damage to unemployment and public debt of affected countries. In order to provide the conceptual arguments required to analyse the crisis, section 4 contains a review of the lite- rature on exchange rates. Section 5 analyses the main causes of the crisis, which are: i) financial integration and under-assessment of 64
  63. 63. The Future of the Euro risk; ii) local imbalances; and iii) the Great Recession. Finally, sec- tion 6 includes the main conclusions reached in the article and establishes the requirements to be met by the roadmap in order to put an end to the Euro Crisis. 2. Historical Background of the Euro The Euro is the first monetary experiment of the 21st century. It is not the first in history and shall not be the last, but it affects an economy like that of the Eurozone which accounts for 15% of the GDP and for 40% of world exports. The European Union is a poli- tical project designed to prevent a third world war in Europe. The first assignment of sovereignty was control by a supranational body of the coal and steel production in France and Germany, basic raw materials to produce weaponry. Europe was not an optimal monetary area; therefore, if a country suffered from an asymmetri- cal disturbance which did not affect the rest and it saw the effects thereof on tis unemployment rate, this could not be offset by wor- kers migrating to other countries with lower unemployment rates. The bubble in Spain is a good example of this. Spain created one third of the jobs in the Eurozone during the boom years, but wor- kers from Germany, where the unemployment rate was reaching historical levels, did not come: instead, it was workers from outsi- de the Eurozone who came. When the bubble burst, our unem- ployment rate shot up, but very few Spanish workers have gone to work in Germany. 65
  64. 64. Nature and Causes of the Euro crisis The example of an optimal monetary area is always the US. However, we tend to forget that in order to get there; they first had to annihilate the original settlers and then have a civil war which led to a default on payment of foreign debt. The European project belongs to the 21st century and when in Asia, America or Africa integration processes begin, they look to Europe for inspi- ration. Nevertheless, the Euro was a risky headlong rush. Since the end of the Bretton Woods agreement, Europe has tried to avoid the unfair competition of competitive devaluations within a cus- toms union. Germany, with the strongest currency in the system, has always led the monetary agreements, as its companies suffe- red the industrial delocalisation created by devaluations, mainly that of the Italian Lira, a country a few hours away by lorry from Bavaria. After the fall of the Berlin Wall, the acceleration of the monetary union was decided so that it would become the striker of the political union. However, the political union reached stag- nation after the severe German crisis of 2000, and the single currency project began to crack. 3. Nature of the Euro Crisis The nature of the crisis which is hitting the European Union is a classical debt deflation crisis (Fischer, 1933). Since the Great Depression, this type of crisis had mainly taken place in emerging countries and was associated with countries with financial vulne- rability, with little tradition of macroeconomic stability and insti- 66
  65. 65. The Future of the Euro tutional fragility. Japan had suffered a crisis of this kind in the nineties and its economy is today trapped under deflation and liquidity, but it was viewed as an exotic case in the Far East. In 2008, the Great Recession led to an abrupt disruption of the paths of growth in developed economies, and the ghost of the Great Depression began to haunt the world. By contrast, the decisive and coordinated action of global economic policies prevented another Great Depression (Eichengreen, 2010). Since then, world trade and industrial production are 10% higher to levels prior to the Great Recession, although the MSCI world stock index continues to be 20% below the levels of spring 2008. Nonetheless, the crash of Lehman Brothers led to the collapse of world trade, and all countries and areas entered abruptly into reces- sion, which favoured policy coordination. But the recovery from 2009 was asymmetric, and the coordination of world economic policies was conspicuously absent. In the Eurozone, from summer of 2008 to spring of 2009, the euphoria in support of an interven- tion to avoid a depression gave way to exit strategies in autumn of that same year and to begin implementing these in spring of 2010. The debt crisis affected a country with huge imbalances in the balance of payments and high level of indebtedness such as Greece, which accounts for 2% of the GDP and population of the Eurozone, and has extended first to Ireland, then to Portugal, and now to Italy and to Spain. One third of the GDP of the area is alre- ady affected, and it has thus become a systemic and global pro- blem. This is a crisis in the balance of payments, but the existence 67
  66. 66. Nature and Causes of the Euro crisis of a currency and the high level of indebtedness mean the lack of any comparable historical precedents, which in turn makes the diagnosis and the search for policies to solve it much harder. For this reason, we must carry out a review of classical literature on exchange rates in order to establish the conceptual bases for the explanation of the crisis, without which the search for a solution would become a random wander. 4. Fixed exchange rates versus flexible exchange rates: a review An exchange rate is a relative price between two hypothetical shopping baskets of two countries. However, exchange rates are closely related to interest rates (Keynes, 1992), and we are therefo- re speaking of a relative price which is essential when explaining economic development. Probably for this reason and as a result of the advance of globalisation, both commercial and financial since the fifties, in recent decades economists have paid special attention to exchange rates. Exchange rates can be: i. Free floating: the exchange rate is set freely in the market on the basis of supply and demand, without the intervention of the central bank or the government of a country. The Euro and the Dollar are the closest free floating currencies. ii. Dirty or managed float: the government or central bank suppo- sedly does not intervene but there are verbal interventions or 68
  67. 67. The Future of the Euro changes in monetary policy which attempt to alter the bases of supply and demand in the currency market. At times of maxi- mum volatility both the US government and the European ones verbally intervene in the market. During the Great Recession, the Federal Reserve, without expressly acknowledging this, has applied a monetary policy which has significantly weakened the dollar. The ECB has always followed in the footsteps of the Fed but in 2011 it managed to exceed its action by weakening the Euro, also without express recognition thereof. Japan is without question the best example of dirty flotation. The country sup- posedly enjoys free exchange rates but when there is tension in the markets and the savers repatriate capital, the central bank intervenes massively in the currency market to counteract the pressures of appreciation on its currency, which would have a very negative repercussion on activity and employment. iii. Fluctuation bands: the European Monetary System or EMS, the predecessor of the Euro, was the clearest example of this system. A central parity and fluctuation bands were established. Whilst the exchange rate in the market fluctuated within the bands, the system behaved like a flexible currency rate, but if it reached the bands then the central bank intervened to prevent these being exceeded, therefore becoming a fixed Exchange rate. iv. Fixed on a currency basket: equal to a fixed rate, but instead of fixing the anchor on one single currency it is fixed on a basket. It has been speculated for some time that China wants to apply 69
  68. 68. Nature and Causes of the Euro crisis this system. It makes more sense that just fixing it against the dollar, as the basket should replicate the composition of the current account and financial balance and would allow for bet- ter stabilisation of real exchange rates, which are the ones which determine the impact on activity and employment. v. Fixed adjustable: this is a fixed exchange rate which allows for adjustments. These may be discretionary or else subject to rules such as in the Bretton Woods system, or periodically adjustable. The latter were used in emerging countries which had sustained soaring inflation rates in the eighties and nineties during their stabilisation programmes, especially in Latin America. vi. Non-adjustable or true fixed rate: the country fixes a nominal anchor with a fixed rate relative to another currency with no possibility of change. Middle Eastern countries have fixed exchange rates against the dollar, which is justified by income from oil being collected in dollars. China had a fixed exchange rate against the dollar until 2005, when it moved onto daily fluctuation bands which it has recently broadened to +/- 1% daily. vii. Cash conversion: the monetary supply of a country is determi- ned by the level of currency reserves, and thus monetary sove- reignty is subject to capital flows. This was the exchange system in Argentina until 2001. 70

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