This document provides an overview of Jesús Fernández-Villaverde's presentation on the long-term sustainability of monetary and fiscal unions like the Eurozone. Some of the key ideas discussed are that monetary unions induce changes to member countries' political economies, both reinforcing and undermining sustainability. Understanding these changes is important to building a successful union. Evidence shows the euro reduced reform incentives in harder-hit periphery nations and increased them in Germany. Booms can obscure governance quality and change incentives and selection of politicians. There were two types of problems among troubled Eurozone nations: public debt issues for Greece and Portugal, and large real estate bubbles for Ireland and Spain.

1. Long-term sustainability
of a monetary and …scal union
Jesús Fernández-Villaverde
University of Pennsylvania
October 6, 2015

2. Motivation
I My presentation today is based on:
1. Political Credit Cycles: The Case of the Euro Zone, with Luis Garicano
and Tano Santos, Journal of Economic Perspectives, 2013.
2. An Institution Too Far: The Political Economy of the Euro, with Tano
Santos.
I Product, as well, of our engagement with the policy debate in Spain
since 2008:
1. Why did policymakers do not react in time to what were rather obvious
imbalances?
2. Why did policymakers “gamble for resurrection” from 2008 to 2012?
I Our view evolved over time from policy mistakes to the central role of
political economy.

3. Key ideas
1. Monetary and …scal unions induce large changes in the political
economy of the member countries.
2. Some changes reinforce the sustainability of the union...
3. ...but some do not.
4. Therefore, understanding these changes (and how to react to them) is
fundamental to build a successful union.
5. However, since we are dealing with a complex political-economic
equilibrium, some of the mechanisms at work are hard to identify and
forecast.

4. The naive view
“After entry into the euro area, the Bank of Greece will be
implementing the single monetary policy decided by the Governing
Council of the European Central Bank and it will certainly be
impossible to improve the economy’s international competitiveness
by changing the exchange rate of our new currency, the euro. The
objectives of higher employment and output growth will therefore
have to be pursued through structural reforms and …scal measures
aimed at enhancing international competitiveness by increasing
productivity, improving the quality of Greek goods and services and
securing price stability.” (Lucas Papademos, Greece Central Bank
Governor, at a conference to mark Greece’s entry to the Euro,
2001).

5. Interest rate convergence

6. External indebtness and private credit

7. Germany

8. The evidence
1. There were some reform processes already under way prior to the
launching of the euro.
2. Euro membership reduced incentives for reform where the need was
more acute (periphery)...
3. ...and increased them were the need was thought to be less acute
(Germany).
4. Persistence: abandonment of reforms and the institutional deterioration
4.1 prolonged the credit boom,
4.2 delayed the response to the burst,
4.3 reduced the growth prospects of these countries.

9. Booms: information extraction
“You never know who’s swimming naked until the tide goes out.”
Warren Bu¤et
I During a bubble, accountability is lost.
I A simple signal extraction model for a principal (voters, shareholders,
...) to understand the quality of governance by the agent (government,
top management, ...) in the tradition of Holmström (1999).
I A transition equation:
qt = f (qt 1, et , ηt )
I A measurement equation:
yt = h (qt , et , νt )

10. Booms: incentives and selection
I Think now about the game between an agent and a principal.
I Principal needs to decide whether to keep the agent (re-elect the
government, …re the management).
I Agent picks a sequence of et to maximize:
Et ∑u (wt , et )
I Changes in et along the equilibrium path.
I Selection e¤ect.

11. Two genera
I Often, the four large European countries that entered in a memorandum
of understanding (Greece, Portugal, Ireland, and Spain) are grouped
together.
I However, there were two genera of problems:
1. Greece and Portugal: public debt.
2. Ireland and Spain: large real state bubbles.
I Because of time constraints, today, I will only talk about Spain.

12. Population 15-64

14. Party systems and monetary and …scal unions
I Party systems are endogenous (note: I use “party system” in a wide
sense).
I Consequence (and …xed point) of:
1. Composition of constituencies.
2. Interests of constituencies.
3. Historical cleavages.
I Entering into a monetary and …scal union changes the party system.

15. Evidence
I Euro crisis:
1. Greece: Syriza, To Potami.
2. Spain: Ciudadanos, Podemos, CUP.
3. Other countries?
I U.S. after Civil War.

16. Agenda
I Experience from previous monetary unions and …xed exchange rate
regimes:
1. Return and abandonment of the Gold Standard by U.K., 1925-1961.
2. France, 1931-1936 and 1983.
3. Other countries?
I Interaction between underlaying economic conditions and the political
economy.
I (More tentative): o¤er practical recommendations.