The Future of the Euro (Brown book 2012)

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


Brown Book
Madrid, July 2012

EDITION SPONSORED BY

© 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


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

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

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

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

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

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

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

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

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

/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

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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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

38
Table 2
Imbalances at the EMU

Source: European Commission (2012): First Alert Mechanism Report (moving averages, 3 or 5 years)


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


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


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


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


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


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


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


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


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


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


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


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


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


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

Table 4
Structural capacity of the developed economies

Source: BBVA Research (2010) based on IMF (2010) and Hall & Soskice (2010)

53


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


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


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


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


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


- BBVA Research (2010): Spain Economic Watch. Noviembre.

- Bean, Ch. (2004): “Asset Prices, Financial Instability, and
Monetary Policy”. The American Economic Review, 94(2), 14-18.

- Bean, Ch. (2010): “The Great Moderation, the Great Panic and
the Great Contraction”.

- Bi, H. (2012): “Sovereign Default Risk Premia, Fiscal Limits, and
Fiscal Policy”. European Economic Review, 56 (2012) 389–410.

- Blanchard, O. y F. Giavazzi (2002): “Current account deficits in
the euro area: the end of the Feldstein-Horioka puzzle?” Brookings
Papers on Economic Activity, 147-186.

- Blanchard, O. (2011): “Blanchard on 2011’s Four Hard Truths”.
Vox EU.

- Bordo, M. y O. Jeanne (2002): “Monetary Policy and Asset Prices:
Does 'Benign Neglect' Make Sense?” International Finance, 5(2), 139-
64.

- Borio, C. y W. White (2004): “Whiter monetary and financial sta-
bility? the implicatios of evolving policy regimes”. BIS Working
Papers No 147.

59


- Cecchetti, S., M. Mohanty y F. Zampolli (2010): “The Future of
Public Debt: Prospects and Implications”. BIS Working Paper No.
300.

- Comisión Europea (2009): "Impact of the Current Economic and
Financial Crisis on Potential Output". European Economy
Occasional Papers, 49.

- Comisión Europea (2012): First Alert Mechanism Report.

- Corsetti, G., A. Meier y G. J. Müller (2011): “Fiscal stimulus with
spending reversals“. The Review of Economics and Statistics (en prensa).
- DeLong, J. B. and L. H. Summers (2012): “Fiscal Policy in a
Depressed Economy”. Mimeo.

- Delpla, J. y J. von Weizsäcker (2010): “The Blue Bond Proposal”.
Bruegel Policy Brief.

- Doménech, R. y M. Jiménez (2010): ”La Primera Gran Crisis de la
Unión Económica y Monetaria”, Pensamiento Iberoamericano, 6, 49-
80.

- Edwards, S., 2002. "Does the Current Account Matter?," en
Sebastian Edwards y Jeffrey A. Frankel, eds, Preventing Currency
Crises in Emerging Markets, pages 21-76 NBER.

60


- Ehrmann, M., M. Fratzscher, R.S. Gurkaynak y E.T. Swanson
(2011). ‘Convergence and Anchoring of the Yield Curves in the
Euro Area’, The Review of Economics and Statistics, 93(1), 350–64.

- Favero, C. y A. Missale (2012): “Sovereign Spreads in the
Eurozone: Which Prospects for a Eurobond?” Economic Policy,
27(70), 231–273.

- FMI (2010), “Regional Economic Outlook. Europe”.

- Galí, J. y L. Gambetti (2009): "On the Sources of the Great
Moderation." American Economic Journal: Macroeconomics, 1(1):
26–57.
- Hall, Peter A. y David Soskice, 2001a: An Introduction to Varieties
of Capitalism. In: Peter A. Hall y David Soskice (eds.), Varieties of
Capitalism: The Institutional Foundations of Comparative Advantage.
Oxford: Oxford University Press, 1–70.

- Florence J. y P. Sodsriwiboon (2010): “Current Account
Imbalances in the Southern Euro Area”. WP/10/139. IMF.

- Lane, P. (2010): A European Perspective on External Imbalances.
Swedish Institue for European Policy Studies. Report nº 5.

- Leeper, E. M. y T. B. Walker (2011): “Fiscal Limits in Advanced
Economies”. Working Paper 16819. NBER.

61


- Obstfeld, M. (2012): “Does The Current Account Still Matter?”
Working Paper 17877. NBER.

- Pisani-Ferry, J. y A. Sapir (2010): "Banking crisis management in
the EU: an early assessment". Economic Policy, 341-373.

- Rojan, R. (2005): “Has Financial Development Made The World
Riskier?”. NBER WP 11728.

- Reinhart, C. M. y K. Rogoff (2008): “Is the 2007 US Sub-Prime
Financial Crisis So Different? An International Historical
Comparison”. American Economic Review, 98(2), 339–344.

- Reinhart, C. M. y K. Rogoff (2009): This Time is Different: Eight
Centuries of Financial Folly. Princeton University Press.

- Shambaugh, J. C. (2012): “The Euro’s Three Crises”. Brookings
Papers on Economic Activity (de próxima publicación).

62

/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

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


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


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


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


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


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


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

The Future of the Euro (Brown book 2012)

The Future of the Euro (Brown book 2012)

Recommended

Recommended

More Related Content

Similar to The Future of the Euro (Brown book 2012)

Similar to The Future of the Euro (Brown book 2012) (20)

More from Círculo de Empresarios

More from Círculo de Empresarios (20)

Recently uploaded

Recently uploaded (20)

The Future of the Euro (Brown book 2012)