CHALLENGES OF THE EUROZONE – CAN THE EURO SURVIVE?

Peter Bofinger

Universität Würzburg

German Council of Economic Experts

Presented at the 2017 Annual Lecture in Economics of the Cyprus Economic Society

Nicosia, 25 May 2017

Outline

I. Euro crisis: What went wrong?

II. How the Euro was saved, so far at least

III. How effective are structural reforms?

III. The great divide: Maastricht 2.0 versus Euro 2.0

IV. Intermediate solutions

2

I. What went wrong?

3

Dismal growth performance of the EZ since 2007

-6

-4

-2

0

2

4

6

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

GDP Growth

United States Euro area

85

90

95

100

105

110

115

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

GDP (2007=100)

United States Euro area

4 Source: OECD, Economic Outlook Annex Tables

Fiscal policy response was too weak

-14

-12

-10

-8

-6

-4

-2

0

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Fiscal balances (percent of GDP)

United States Euro area

Source: OECD, Economic Outlook Annex Tables 5

ECB policy rate was too high

-1

0

1

2

3

4

5

6

Jan

-04

Jun

-04

No

v-0

4

Ap

r-0

5

Sep

-05

Feb

-06

Jul-

06

Dec

-06

May

-07

Oct

-07

Mar

-08

Au

g-0

8

Jan

-09

Jun

-09

No

v-0

9

Ap

r-1

0

Sep

-10

Feb

-11

Jul-

11

Dec

-11

May

-12

Oct

-12

Mar

-13

Au

g-1

3

Jan

-14

Jun

-14

No

v-1

4

Ap

r-1

5

Sep

-15

Feb

-16

Jul-

16

Dec

-16

%

Short-term interest rates (1-month LIBOR)

Euro Area USA

6 Source: FRED, Federal Reserve Bank of St. Louis

Quantitative easing was delayed

0

1

2

3

4

5

6

7

Jan

-99

Dec

-99

No

v-00

Oct

-01

Sep

-02

Au

g-03

Jul-

04

Jun

-05

May

-06

Ap

r-0

7

Mar

-08

Feb

-09

Jan

-10

Dec

-10

No

v-11

Oct

-12

Sep

-13

Au

g-14

Jul-

15

Jun

-16

10-year bond yield

Euro-Benchmark 10-year US Treasury

0

5

10

15

20

25

30

Per

cen

t

Bond holdings of central banks (percent of GDP)

ECB Federal Reserve

7 Sources: ECB, Federal Reserve Bank of St. Louis, Board of Governors

The Euro Area‘s main problem

8

Bond-Run: Financial markets in panic

0

100

200

300

400

500

600

700

Bas

is p

oin

ts

10-year bond spreads over German Bunds

Italy Spain

9 Source: Thomson Reuters Datastream

Vicious circle of the problem countries .

Macroeconomic crisis

Banking crisis Government debt crisis

10

II. How the Euro was saved – so far at least

11

Mario Draghi‘s magic moment "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."

12

Risk premia declined substantially

0

100

200

300

400

500

600

700

Bas

is p

oin

ts

10-year bond spreads over German Bunds

Italy Spain

13 Source. Thomson Reuter Datastream

Silent paradigm change in 2014

-2

-1

0

1

2

3

4

5

6

7

2011 2012 2013 2014 2015 2016

Change in structural balance (percentage points)

France Germany Greece Italy Portugal Spain Euro area

75

80

85

90

95

100

105

110

115

2010 2011 2012 2013 2014 2015 2016

GDP (2010=100)

France Germany Greece Italy

Portugal Spain Euro area

14 Source: OECD, Economic Outlook, Annex Tables

The risk of deflation in the euro area

-1

0

1

2

3

4

5

Jan

19

99

Jun

19

99

No

v 19

99

Ap

r 2

00

0

Sep

20

00

Feb

20

01

Jul 2

00

1

De

c 2

00

1

May

20

02

Oct

20

02

Mar

20

03

Au

g 20

03

Jan

20

04

Jun

20

04

No

v 20

04

Ap

r 2

00

5

Sep

20

05

Feb

20

06

Jul 2

00

6

De

c 2

00

6

May

20

07

Oct

20

07

Mar

20

08

Au

g 20

08

Jan

20

09

Jun

20

09

No

v 20

09

Ap

r 2

01

0

Sep

20

10

Feb

20

11

Jul 2

01

1

De

c 2

01

1

May

20

12

Oct

20

12

Mar

20

13

Au

g 20

13

Jan

20

14

Jun

20

14

No

v 20

14

Ap

r 2

01

5

Sep

20

15

Feb

20

16

Jul 2

01

6

Dec

20

16

HICP Inflation Rate

Inflation rate Core inflation ECB inflation target

Source: ECB 15

No indications of a new financial bubble in the EZ

0

100

200

300

400

500

600

19

99

-01

19

99

-05

19

99

-09

20

00

-01

20

00

-05

20

00

-09

20

01

-01

20

01

-05

20

01

-09

20

02

-01

20

02

-05

20

02

-09

20

03

-01

20

03

-05

20

03

-09

20

04

-01

20

04

-05

20

04

-09

20

05

-01

20

05

-05

20

05

-09

20

06

-01

20

06

-05

20

06

-09

20

07

-01

20

07

-05

20

07

-09

20

08

-01

20

08

-05

20

08

-09

20

09

-01

20

09

-05

20

09

-09

20

10

-01

20

10

-05

20

10

-09

20

11

-01

20

11

-05

20

11

-09

20

12

-01

20

12

-05

20

12

-09

20

13

-01

20

13

-05

20

13

-09

20

14

-01

20

14

-05

20

14

-09

20

15

-01

20

15

-05

20

15

-09

20

16

-01

20

16

-05

20

16

-09

20

17

-01

MFI loans to the private sector (January 1999=100)

Euro area Germany Spain Italy France Ireland

16 Source: ECB

III. How effective are reforms?

17

Responsiveness to reforms is not so bad

0,0

10,0

20,0

30,0

40,0

50,0

60,0

70,0

80,0

Responsiveness to OECD Going for Growth recommendations

Responsiveness rate, 2013-14 Responsiveness rate, 2015-16

Source: OECD Going for Growth 18

Employment protection legislation I

19

0,00

0,50

1,00

1,50

2,00

2,50

3,00

3,50

Protection of permanent workers against individual and collective dismissals

Source: OECD

Employment protection legislation II

20

0,00

1,00

2,00

3,00

4,00

5,00

6,00

Regulation on temporary forms of employment

Source: OECD

Are Hartz IV reforms a model for other countries? Net income replacement rates for unemployment (percent)

0

10

20

30

40

50

60

70

80

90

100

0

10

20

30

40

50

60

70

80

90

100

GR

C

KO

R

AU

S

TU

R

US

A

NZ

L

LTU

CH

L

ES

T

GB

R

PO

L

HU

N

SW

E

SV

K

FR

A

OE

CD

ES

P

AU

T

DE

U

EU

ITA

CZ

E

CA

N

NO

R

IRL

JPN

ISL

PR

T

BE

L

NLD

LVA

CH

E

SV

N

FIN

DN

K

ISR

LUX

Initial

2014 2009

Average (2014)

0

10

20

30

40

50

60

70

80

90

100

0

10

20

30

40

50

60

70

80

90

100

ITA

TU

R

CH

L

GR

C

US

A

HU

N

LTU

PR

T

ES

P

KO

R

ISR

SV

K

ES

T

LVA

PO

L

OE

CD

CA

N

EU

AU

S

FR

A

NZ

L

CZ

E

BE

L

SV

N

DE

U

SW

E

GB

R

JPN

NO

R

CH

E

DN

K

ISL

NLD

LUX

AU

T

FIN IRL

60th month

2014 2009

Average (2014)

Source: OECD, Going for Growth 2017 21

Wage moderation for all?

70

80

90

100

110

120

130

140

150

160

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Unit labour costs (1999=100)

Germany Ireland Greece Spain France Italy Netherlands ECB-Norm

22 Source: AMECO Database

German wage increases are still too low

-4,0

-2,0

0,0

2,0

4,0

6,0

8,0

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Increase in Unit Labour Costs and ECB Inflation Target (percent)

Unit Labour Costs (per hour) ECB Inflation Target

23 Source: Destatis

Does Michigan need structural reforms?

0

1

2

3

4

5

6

Gre

ece

Mic

hig

an

Ital

y

Po

rtu

gal

Lou

isia

na

Mis

siss

ipp

i

Mai

ne

Oh

io

Mis

sou

ri

Co

nn

ect

icu

t

Ken

tuck

y

Wes

t V

irgi

nia

Del

awar

e

Illin

ois

Ne

w J

ers

ey

Rh

od

e Is

lan

d

Ala

bam

a

Ge

rman

y

Fran

ce

Ind

ian

a

Ne

the

rlan

ds

Wis

con

sin

Ge

org

ia

Fin

lan

d

Sou

th C

aro

lina

Au

stri

a

Ne

w Y

ork

Ver

mo

nt

Bel

giu

m

Ark

ansa

s

Kan

sas

Ne

w M

exi

co

Ten

nes

see

Pen

nsy

lvan

ia

Spai

n

Ne

w H

amp

shir

e

Ne

vad

a

No

rth

Car

olin

a

Flo

rid

a

Min

ne

sota

Vir

gin

ia

Ala

ska

Was

hin

gto

n

Mas

sach

use

tts

Ari

zon

a

Haw

aii

Dis

tric

t o

f C

olu

mb

ia

Co

lora

do

Iow

a

Mar

ylan

d

Mo

nta

na

Idah

o

Ne

bra

ska

Cal

ifo

rnia

Wyo

min

g

Okl

aho

ma

Uta

h

Sou

th D

ako

ta

Ore

gon

Texa

s

Irel

and

No

rth

Dak

ota

Average GDP growth rates (1999-2015)

24 Source: Ameco and Bureau of Economic Analysis

IV. The great divide: Maastricht 2.0 versus Euro 2.0

25

Polar views on the insolvency problem

Maastricht 2.0:

Insolvency risk is a positive feature: necessary for achieving full market discipline

Strict no-bail out and formal insolvency procedures for sovereigns

Fiscal competences at the national level

Euro 2.0

Insolvency risk is a negative feature: exposes member states to unpredictable effects of market forces

Debt mutualisation

Transfer of fiscal competences to EZ-level (EMF, EFI, European Finance Minister)

26

Two views on market discipline

Feld et al. (2016, p.55):

“An insolvency mechanism for sovereigns that credibly stipulates a creditor bail-in would not only help with burden sharing (similar to the bail-in rules for the banking sector), but also give creditors incentives to assess the default risks of government bonds and loans accurately and factor them in when calculating risk premiums. This should result in ex -ante disciplining of government budgetary policy and would, thus, support crisis prevention.“

Delors-Report (1989):

“ (…), experience suggests that market perceptions do not necessarily provide strong and compelling signals and that access to a large capital market may for some time even facilitate the financing of economic imbalances. Rather than leading to a gradual adaptation of borrowing costs, market views about the creditworthiness of official borrowers tend to change abruptly and result in the closure of access to market financing. The constraints imposed by market forces might either be too slow and weak or too sudden and disruptive.”

27

Underlying assumptions of reform proposals More political integration is not

possible

More political integration is

possible

Market discipline more effective

than political discipline/Markets

self-stabilizing

Maastricht 2.0: Insolvency regime

for Euro area

(German Council of Economic

Experts majority)

Hybrid forms of

Maastricht2.0/Euro 2.0

Political discipline more effective

than market discipline/Markets

need stabilization by state

Muddling through

Stabilising the the Status quo

which relies on heavy ECB support

(QE/OMT)

Euro 2.0: Some form of debt

mutualisation. Transfer of policy

competences to the Euro area

level

28

V. Intermediate solutions

29

Intermediate solutions

• More effective fiscal policy coordination in the European Semester

• Golden rule for the Stability and Growth Pact

• Debt mutualisation for new debt, related to joint investment projects or for debt raised in exceptional conditions

• EZ unemployment insurance

• EZ budget

30

Main challenges of the Eurozone

• Insolvency risk

• Insufficient fiscal policy coordination

• Beggar-my-neighbour policies

• Compensation of regions which are negatively affected by trade shocks

• Willingness to reform detrimental political and economic structures

31

Can the Euro survive?

32