Institutions of Macroeconomic Policy
Advanced Workshop on Global Political Economy,
Institute for Global Law & Policy, Harvard Law School
Lecture III, June 1, 2012
The Euro Crisis
Was European Monetary Union
a bad idea from the start?
Seven mistakes by euro leaders
Appendices: Looking forward
Was European Monetary Union
a bad idea from the start?
Monetary: A firm Monetary: Loss of ability
nominal anchor to end by each to respond
inflation among to local conditions
Mediterranean by adjusting money
countries. supply, interest rate,
Trade: To promote EU or exchange rate.
economic integration. Political
Political: (according to M.Feldstein):
To improve cohesion. Could lead to conflict.
The major grounds for ex ante skepticism
among (American) economists
The euro countries did not meet the criteria
of an Optimum Currency Area
– OCA: Bob Mundell, 1961 (another Nobel Prize).
Individual members would be hit
by individual (“asymmetric”) shocks.
– Lacking the high labor mobility of the US,
– where workers adjust to unemployment by moving across states,
– euro members would find it very difficult
to abide by a common monetary policy.
– E.g., when a periphery country suffered a loss in demand,
the interest rates set in Frankfurt would be too high for it.
Comments on “The euro: It can’t happen, It’s a bad idea, It won’t last. U.S. economists on the EMU, 1989-2002,” by Jonung & Drea. Euro at 10, 2009 ASSA mtgs.
In retrospect, economists were correct
to worry about “asymmetric shocks”
(1) the shocks were excessive credit-fueled booms
in the periphery countries (2003-07), rather than recessions,
– with Ireland & Spain unable to raise interest rates or appreciate; and
(2) the booms showed up in asset prices (housing)
– more than in goods market inflation.
(3) Only after the Global Financial Crisis began in 2008
– was the need felt to fight recession with depreciation
E.g. Poland had the best performance, the Baltics had the worst.
And only after the Greek crisis began in Oct. 2009
did the need to devalue become so acute
as to prompt thoughts of leaving the euro. 5
But the Maastricht Treaty (Dec. 1991)
focused on fiscal criteria
as qualifications for euro membership:
BD < 3% of GDP & Debt < 60% of GDP.
One might have thought that, giving up the
instrument of monetary policy, it would
become more important for countries to retain
the instrument of fiscal policy.
Why did the designers of Maastricht
emphasize fiscal criteria?
Theory I: Jason
& the Golden Fleece
& the stone
Theory III: Odysseus
& the sirens.
Frankel, Economic Policy (London) 16, April 1993, 92-97.
The motivation for the Maastricht fiscal criteria
was the same as for the No Bailout Clause
and the Stability & Growth Pact (1997):
Skeptical German taxpayers believed that, before
the € was done, they would be asked
to bail out profligate Mediterranean countries.
European elites adopted the fiscal rules
to render these fears were groundless.
7 mistakes made by euro leaders
Admitting Greece to the € in the first place,
– a country that was not yet ready by the relevant criteria.
Pretending to enforce the fiscal criteria.
Allowing Mediterranean countries’ bond spreads near 0
– helped by investors’ under-perception of risk (2003-07)
– and artificial high credit ratings. But also
– ECB acceptance of Greek bonds as collateral.
Burying their heads in the sand when the crisis hit in late 2009:
In early 2010, sending Greece to the IMF was “unthinkable.”
In early 2011, restructuring of the debt was “unthinkable.”
The current strategy:
austerity for now,
unenforceable “Fiscal Compact” for the future.
After the euro came into existence
it became clear the German taxpayers had been right
– and the European elites had beene wrong.
E.g., Greece persistently violated the 3% deficit rule.
All members violated the rules at some time, large & small.
SGP targets were “met” by overly optimistic forecasts.
SGP threats of penalty had zero credibility.
Yet each year the ostrich elites stuck
their heads deeper & deeper into the sands. 10
The Greek budget deficit
never got below the 3% of GDP limit,
nor did the debt ever decline toward the 60% limit
Even Greece’s primary budget deficit
has been far in excess of 3% since 2008
Spreads for Italy, Greece, & other Mediterranean
members of € were near zero, from 2001 until 2008.
Market Nighshift Nov. 16, 2011 13
When PASOK leader George
Papandreou became PM in Oct. 2009,
– that “foul play” had misstated the fiscal
statistics under the previous government:
– the 2009 budget deficit ≠ 3.7%,
as previously claimed,
but > 12.7 % !
The EMU elites had to know that someday
a member country would face a debt crisis.
In early 2010 they should have viewed Greece as a
good opportunity to set a precedent for moral hazard:
– The fault egregiously lay with Greece itself,
unlike Ireland or Spain, which had done much right.
– It is small enough that the damage from debt restructuring
could have been contained at that time.
They should have applied the familiar IMF formula:
serious bailout, but only conditional on serious
policy reforms & serious Private Sector Involvement.
But the ostriches
stuck their heads
down in the sand.
– Greece, Ireland and Portugal went to the IMF; and
– Greek debt was restructured.
But by then
interest rates and debt/GDP ratios were far higher,
it was too late to draw a line credibly distinguishing
Greece from the others, even Spain and Italy.
Any solution to the euro crisis must include:
(i) a way of putting the member countries
back on sustainable paths (≡ debt/GDP declining).
(ii) a way of preventing repeats in the future.
– As the Maastricht architects knew all along,
this means a way of preventing fiscal moral hazard:
preventing individual countries from running big deficits
& debts, expecting to be bailed out in the event of a crisis.
(i) Putting countries back on sustainable paths?
The 6th mistake:
the German belief that fiscal contraction is expansionary.
– It is the same mistake made now by the UK & some in the US,
– and is the same mistake made in 1937.
As a result, Debt/GDP ratios in euro countries are rising,
– not falling;
= the definition of unsustainable financially,
even if you thought the economic hardship
was sustainable politically.
(ii) Preventing moral hazard in the future?
The 7th mistake is Merkel’s “fiscal compact”:
– yet another unenforceable declaration
of determination to strengthen the SGP,
– via budget limits in national laws/constitutions.
– Why should these rules
be any more credible
than those that came before?
References by the speaker
“The Hour of the Technocrats,” Project Syndicate, Nov.15, 2011.
“The ECB’s Three Big Mistakes,” VoxEU, May 16, 2011.
“Optimal Currency Areas & Governance", slides session on the Challenge of Europe at the Annual
Conference of George Soros’ INET, April 2011; video available, including my presentation.
"Let Greece Go to the IMF," Jeff Frankel’s blog, Feb.11, 2010.
Over-optimism in Forecasts by Official Budget Agencies and Its Implications," Oxford
Review of Economic Policy, 2011.
“A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by
Chile,” Fiscal Policy and Macroeconomic Performance, Central Bank of Chile,
2011. NBER WP 16945, April 2011.
“The Estimated Effects of the Euro on Trade: Why are They Below Historical Evidence
on Effects of Monetary Unions Among Smaller Countries?” in Europe and the Euro,
Alberto Alesina & Francesco Giavazzi, eds. (U.Chic.Press), 2010.
"Comments on 'The euro: It can’t happen, It’s a bad idea, It won’t last. U.S. economists
on the EMU, 1989-2002,' by L.Jonung & E.Drea," slides. Euro at 10: Reflections on
American Views, ASSA meetings, San Francisco, 2009.
"The UK Decision re EMU: Implications of Currency Blocs for Trade and Business
Cycle Correlations," in Submissions on EMU from Leading Academics (H.M. Treasury:
"The Endogeneity of the Optimum Currency Area Criterion," with Andrew Rose, The
Economic Journal, 108, no.449, July 1998.
“‘Excessive Deficits’: Sense and Nonsense in the Treaty of Maastricht; Comments on
Buiter, Corsetti and Roubini,” Economic Policy, Vol.16, 1993. 21
• (A) In the US system, how do the
fiscal policies of the 50 states
avoid moral hazard?
• (B) The ECB’s LTROs (Dec. 2011-Feb 2012)
• (C) Any solution for the long term?
• (D) Restoring competitiveness
via the exchange rate: Poland vs. the Baltics
Appendix A: Perhaps the Fiscal Compact
misunderstands the US system
Yes, despite a common currency, the 50
states do not seem to have moral hazard:
– The federal government has never bailed one out,
and nobody expects it to now.
– But that is not due to the budget
rules that (49 of) the states have.
Their rules are voluntary, varied, and flexible.
Some states do have debt troubles,
– and even default.
How the US avoids moral hazard in the 50 states
Government spending at the state level is a far
smaller share of income than at the federal level,
– let alone on the part of European states.
– Is Europe ready for that? No.
When one state begins to run its debt too high,
the private market automatically
imposes an interest rate penalty.
– E.g., California today.
– Gives states the incentives to get back in line.
– This mechanism was expected to operate in euroland
Alesina, et al (EP, 1992) and Goldstein & Woglom (1992).
but conspicuously failed from the first day.
– Which showed that moral hazard had not been addressed.
Nobody expects the U.S. Federal government
to bail out indebted states: The precedent was set
170 years ago, when 8 states were allowed to default.
In the early 1940s,
5 states repudiated
their debts completely
(Michigan, Mississippi, Arkansas,
Louisiana & Florida) while a few more
were in default for several years.
Spreads help keep
profligate US states in line.
When States Default: 2011, Meet 1841, WSJ 25
California Municipal Bonds
(now the lowest rated of the 50 states)
Credit Default Swaps
Appendix B: Mario Draghi became
President of the ECB, Nov.1, 2011
He was under intense pressure to expand his predecessor’s
purchases of large quantities of periphery-country bonds.
– The ECB was urged to be the “big bazooka”:
to buy troubled governments bonds.
– If the ECB interpreted its mandate literally,
as no more than keeping inflation low,
then the euro might break up.
On the other hand, as Draghi knew:
– the ECB is legally prohibited from financing governments directly;
– If he had bailed out Italy & the others, he would have:
facilitated a continuation of Berlusconi-style irresponsibility;
been immediately written off by Germans as another profligate
Draghi’s LTRO (Longer-Term Refinancing
Operation) was a great success.
On Dec. 22, he caught everyone
by surprise by the clever ploy
of doing exactly what he had
previously announced he would do:
– loans to banks for 3 years, at low interest.
– Brought down interbank & country spreads,
while consistent with central bank LoLR mandate.
2nd round in late February was equally successful.
But the LTRO rounds were not a solution;
– They only bought a little time.
Proposal for the long term #1
successful fiscal institutions:
Give responsibility for determining
what is a structural deficit and what
is a cyclical deficit to an independent
professional agency, to avoid forecast bias.
Proposal for the long term #2
Penalty when a euro country misses its target:
a) The ECB then stops accepting new bonds as collateral.
b) => Sovereign spread rises, with automaticity.
c) Proposal from Brueghel (JvW & ZD):
All of euroland is liable for blue bonds
(issued up to SGP limits);
Issuing country is liable for red bonds
(beyond those limits) .
d) Blue bonds share advantages with other eurobond proposals:
a) ● ECB can conduct monetary policy.
b) ● They could offer an alternative to US TBills
for PBoC & other desperate global investors 30
Blue bonds & red bonds
Source: Gavyn Davies, FT
Appendix D: Restoring competitiveness
via devaluation: Poland vs. the Baltics
Poland, the only continental EU member with a floating
exchange rate, was also the only one to escape
negative growth in the global recession of 2009
% change in GDP (de facto)
Source: Cezary Wójcik, 2010
The Polish exchange rate increased by 35%.
The depreciation boosted net exports; contribution to GDP growth > 100%
Source: Cezary Wójcik
zlotys / $
Contribution of Net X to GDP:
2009: 2,5 3,4 3,2 3,4
> 100% of
Poland’s GDP growth rate: 1,7
kroon / $
lats / $
Advanced Workshop on Global Political Economy,
End of Lecture III
The Euro Crisis