Summary of talk by George Alogoskoufis, Karamanlis Chair at the Fletcher School, Tufts University, at the Weatherhead Center, Harvard University, Tuesday, December 4, 2018
There have been four sub-periods in the evolution of monetary cooperation in the European Union.
First, the period from the collapse of the Bretton Woods system of fixed parities in 1973, to the emergence of the EMS in 1979.
Second, the period of operation of the EMS, until the creation of the euro in 1999.
Third, the first ten years of the euro area, before the crisis of 2009-2010.
Finally, the period since 2010, when the euro crisis broke out.
In each successive sub-period monetary integration was becoming gradually deeper, evolving from the “snake” of the 1970s, to the EMS of the 1980s, the tighter EMS of the 1990s, with infrequent reallignments, and, eventually with the creation of the euro.
All periods were characterized by significant macroeconomic and financial asymmetries among member states in the core and the periphery, but also by different degrees of monetary integration.
With the deepening of monetary cooperation, in the evolution from the snake to the euro, some of these asymmetries were addressed, while others were not.
The main asymmetries addressed by the EMS and the Euro were nominal asymmetries, such as asymmetries in inflation rates.
When the euro was created, very little was done to address the remaining real and financial asymmetries, effectively shifting the burden of adjustment to individual euro area members and their fiscal systems.
As a result, while nominal asymmetries, such as differences in inflation rates, and nominal interest rates were addressed by the creation of the euro, real, financial and external asymmetries widened after the creation of the euro, both before and after the euro area crisis.
In the first ten years since the creation of the euro, real asymmetries resulted in the build up of significant external imbalances between the core and the periphery of the euro area, and, eventually contributed to the eruption of the euro area crisis.
The main financial asymmetric shock appears to have been the creation of the euro itself, which initially brought about the convergence of nominal and real interest rates between the periphery and the core. Nominal and real interest rates in the periphery converged very quickly to the lower levels that existed in the core, as the premium due to exchange rate risk disappeared. In fact, as inflation rates converged much more slowly than nominal interest rates, real interest rates in the periphery fell even more. This convergence resulted in a widening of savings and investment imbalances in the periphery, which up until then had relatively high nominal and real interest rates.
The convergence of interest rates brought about the widening of external imbalances, the buildup of external debt by the countries of the periphery, and created the pre-conditions for the euro area financial crisis.
This process was exacerbated by the “home” bias of banks in the countries of the euro area, due to the fact that the euro area was not a banking union.
The euro area crisis was essentially an “external” debt crisis in an economic and monetary union with a single currency, but major economic and financial asymmetries and significant governance problem areas.
As a result, the euro area crisis of the 2010s was, at the end of the day, no different than other regional financial crises involving indebted economies, such as the Latin American crisis of the 1980s and the Asian crisis of the 1990s.
The proximate cause of the EA crisis was the rapid unwinding of intra-EA lending/ borrowing imbalances that built up in the 2000s, following the US financial crisis of 2007-09. Some of this lending was to private borrowers (especially in Ireland and Spain) and some of it to public borrowers (especially in Greece, Italy and Portugal), but in every case the difficult debt mostly ended up in government hands.
Often private over-indebtedness ends up on governments’ balance sheets, so that the rise in public debt is more a consequence than a cause of a financial crisis.
The ‘sudden stop’ led to a significant crisis rather than a more manageable problem since EA members could not devalue and the ECB could not bail out the governments of the periphery.
A confidence crisis followed, first about the countries of the periphery, but later about some of the core countries, regarding their ability to service their public and private external debts. This was exacerbated by the delayed and unsuccessful initial efforts to address the problem.
The proximate causes of the crisis – imbalances and lack of effective crisis management mechanisms –tell us that there are really three sorts of underlying causes:
- Design and policy failures that allowed the imbalances to develop and get so large
- Lack of institutions to absorb shocks at the EA level.
- Crisis mismanagement
Some of these failures involved unanticipated events. Others were systemic and others were due to a failure to implement the provisions of the treaties.
The major systemic problem areas included,
- Major differences in the product mix between the core and the periphery
- Fragmented national labor markets and low cross border labor mobility
- Widely different fiscal systems
- Imperfect financial integration and lack of effective cross border financial regulation
- An extremely low federal budget that would act as an automatic stabilizer through transfers from booming economies to economies suffering from recession
- Lack of a lender of last resort to banks and sovereign governments it times of crisis.
A result of the major asymmetries and other economic and governance problems of the euro area is the fact that adjustment efforts since the crisis have shifted the burden exclusively towards the weaker economies in the periphery of the euro area, which suffered deep recessions, a significant rise in unemployment, continuous tax rises, exorbitant social costs for young workers and old age pensioners, and rises in government debt to GDP ratios.
The euro area is in urgent need for additional fiscal, financial and labor market reforms.
The most important one is a significant EA budget, through a moderate and appropriately targeted increase in the EU budget. This would help smooth out the asymmetric impact of macroeconomic shocks through the operation of automatic fiscal stabilizers. It would also help EA countries in recession face fewer fiscal and financial consequences of such recessions, and would also partly address labor market fragmentation.
A significant part of the fragmentation of labor markets in Europe is the result of the lack of a cross border system of unemployment and health insurance. This could be addressed in a reform that would allow for a moderate increase in the EU budget targeted to euro area wide unemployment and health insurance.
The objections of net contributors to a moderate increase in the EU budget could in principle be overcome by an appropriate rules based fiscal reform that would address moral hazard and other coordination problems that are usually evoked as counter-arguments.
The EU and the EA are already transfer unions, through the operation of the single market and the monetary union. They encourage significant economic transfers from weaker and less competitive sectors and economies in the periphery, to stronger and more competitive ones, as suggested by the macroeconomic performance of the core and the periphery following the creation of the Euro area.
A fiscal transfer union, which would result from an increase in the EU budget, would partly correct the effects of such transfers through fiscal redistribution, and is a logical counterpart of the single market and the monetary union.
At the same time the banking union should proceed as planned, national reform efforts should be strengthened, especially in the periphery, and the stability and growth pact should be strictly enforced.
Link to Slides of Full Presentation
Link to Video of Mario Draghi’s “Whatever it takes” Statement