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European Integration: a work in progress (regress?)

Joshua Aizenman; UCSC and the NBER

A plenary address European Integration: Past, Present & Future

Wilfrid Laurier University (WLU)

1 January 2009 -- the 10th anniversary of the euro and of the

Euro system. Exactly ten years before the euro was

introduced, first as an electronic means of payment (the banknotes and coins came into circulation in 2002).

In 2008, the accomplishments of the Euro were celebrated in several major conferences.

Overall, the continental European view reflected growing satisfaction with the achievements.

On the short history of the Euro project

The drivers of the Euro project were the core of “Old Europe” – France and Germany.

Skeptical views from the US. Concerns (beyond the fact that stronger € may

reduce global demand for $): The Euro project is a currency union, without

political and fiscal unification. The Euro zone fails conventional ‘Optimal

currency union’ criteria:

The case for ‘Optimal currency union’ is stronger when

Labor Mobility (LM) is high, thereby substituting for the inability to adjust the exchange rate between Germany and (Greece, Spain, Portugal, Ireland, etc), or between California and Texas.

Fiscal Unification (FU) is high, providing implicit insurance by a federal tax and grant system.

Trade within the Monetary union is high. The US meets these criteria more than the

Euro block.

In the absence of strong LM and FU

Symmetry of shocks and structure helps by reducing the gain from independent monetary policy.

US economists were skeptical about the economic case for Euro [Feldstein, Obstfeld, Rogoff, among others].

Yet, time may help, and inefficient monetary union may mature into an efficient one [J. Frankel, see Frankel and Chinn on the $ and Euro future].

The first decade of the Euro: good luck helped…

“Great moderation,” tranquil time, regional and global growth helped in masking burgeoning problems in the Euro block [in the US…].

The illusive “great moderation” intensified unsustainable trends in the weaker underbelly of the Euro block (large and growing current account deficits, and unsustainable housing booms in several countries).

The crisis: the first serious test of the Euro project (as well as of financial globalization).

The outcome: murky.

Unemployment rates

19% 10%

13%

13%

15%23%

ECB's Weber says ECB in a state of 'heightened alertness' on inflation risks,

June 12, 2008 Thomson Financial News

ECB Governing Council Member Axel Weber said the ECB is in a state of 'heightened alertness' and is ready to act given the continuing strong upside risks to price stability.

In a keynote speech in Munich, Weber also said the ECB will continue to provide liquidity to the Euro money market given the ongoing tensions in the longer-term sector but does not 'offer some sort of ex-post insurance to financial market participants who have engaged in excessive risk-taking'.

http://www.forbes.com/feeds/afx/2008/06/12/afx5108529.html

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The Greek crisis is testing the stability and the dispute

resolution capacity of Euro block

Selective contagion?

Most OECD facing fiscal challenges, including the € block

These challenges are the legacy of the welfare state at times of declining fertility and economic growth.

In due course, fiscal tightening will face most OECD, scaling down some of the transfers (making them more progressive, switching to means tested benefits), and possibly higher taxes.

Current & future

government obligations/

GDP.Source:

NYT, 3-12-2010

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The road ahead

Three possible scenarios, ordered by desirability (and hopefully, by plausibility…).

I. The Euro block will muddle through.

II. Due to political reasons, Greece will exit the Euro.

III. The core of Euro will survive (assuming France and Germany would remain committed to the Euro project). Greece’s exit would induce contagion, and possible exit of several weaker members.

I. The Euro block and Greece will muddle through

Stabilization package, probably facilitated via the IMF.

Conditionality (fiscal tightening) in exchange for debt restructuring (longer term debt, possibly with “hair cuts”).

Serious fiscal adjustment of the weaker “southern-belly” of Europe.

Germany and France would support the stabilization [fear of multiple equilibria].

For France and Germany, ‘bailing out’ Greece is akin to bailing out their own banking systems…

French & German banks are exposed to Greek bonds, (58, 32) € BN

II. Greece will exit the Euro block ?

Internal politics in Greece may induce populist pressure to exit the euro block.

A large depreciation to facilitate adjustment, probably large Greek default on € debt overhang.

Exiting the € is not a panacea (see Argentina’s experience--massive banking crisis, inflationary pressure, redistribution of income). At best, modest short term gains, no fix for the need to cut overspending.

Adverse impact on the soft southern-belly of the Euro block (contagion would increase the risk premium).

With luck, the net effect on the remaining Euro block may be modest [Greece counts for 3% of Euro block’s GDP, 11 million residents].

III. The core of Euro will survive

Exit of Greece may lead to a chain reaction, inducing exit of other weak countries.

It may derail the extension of the Euro project, scaling down the prospect that the Euro will overtime become a global currency that will challenge the US dollar.

Dynamic implications of the crisis

The crisis will induce tightening of fiscal rules within the Euro block, leading to gradual convergence of taxes, retirement age, etc…(delaying retirement to 60+, increasing tax collection in weaker countries, etc).

While fiscal unification is not in the cards for the next decade(s), tighter fiscal monitoring would emerge in order to mitigate exposure to a replay of the unfolding Greek tragedy.

These adjustments will induce de-facto fiscal convergence.

Moral hazard: the global crisis, and the Greek fiasco exposed the need to tighten banking

regulations Banks and big financial intermediaries

expose the tax payer to moral hazard associated with the ‘too big to fail’ doctrine.

Greek default would require domestic bailouts in European countries whose banks are heavily exposed to Greek bonds [French & German banks are exposed to Greek bonds, (58 € BN, 32 € BN )

respectively]. The remedy: ex ante monitoring and supervision

of banks’ riskiness, charging a risk premium based on banks’ portfolio’s risk, and funding future bailouts (akin to FDIC’s policy).

To put it into proper perspective

The US dollar started mostly as currency union among states, with scanty fiscal unification.

It took about 200 years for the dollar union to reach the present stage of fiscal and political unification of 50 states.

The process was ugly [Civil War, Great Depression, etc].

Fiscal Federalism in the US

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http://www.gpoaccess.gov/usbudget/fy11/hist.htmlhttp://usgovernmentspending.blogspot.com/

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Concluding remarks Successful muddling through the crisis in

Europe would induce the Euro block to deal with hidden challenges that were unmasked by the crisis.

The global crisis & the Greek/€ crisis illustrate the Paradox of Regulation [Aizenman, NBER WP # 15018]

While the identity of economic agents that benefit directly from crisis avoidance is unknown, the cost and the cumbrance of regulations are transparent. Hence, crises that have been avoided are imperceptible and are underrepresented in the political discourse.

The success of the prudential regulator or a prolonged period of economic tranquility lead to complacency, reducing the demand for regulator’s services, inducing under regulation, which leads to a financial calamity.

Concluding remarks II

The quality of the adjustment of all the participants would profoundly impact the future of the Euro, the speed of extending its reach to Eastern Europe, the global recovery, and the role of € as an international reserve currency.

"The news of the € death has been greatly exaggerated."

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Thanks for your attentionInternet sources

http://www.marketoracle.co.uk/images/2010/Feb/euro-18_image006.jpg

http://www.marketoracle.co.uk/images/Greece_Economy.jpg

http://si.wsj.net/public/resources/images/OB-HR858_greece_G_20100226231010.jpg

http://graphics.thomsonreuters.com/0210/EZ_DBTPH0210.gif

http://media.economist.com/images/20100220/201008EUC041.gif

http://www.ft.com/cms/s/0/8038d17e-167d-11df-bf44-00144feab49a.html#