THE EURO CRISIS – WHAT HAVE WE LEARNED AND WHAT CAN BE DONE?

Christopher A Pissarides

Regius Professor of Economics

London School of EconomicsEssex 50th birthday celebrations, 12 June 2015

1

The Eurozone crisis

• The European Union is clearly not delivering what it promised with the single currency

• What is needed to bring it back to robust growth?

• Does the fault for the prolonged crisis lie with the structure of labour markets or with monetary and fiscal policies?

• Will argue that crisis is due to mismanagement of a single currency when the optimal criteria for an optimal currency area are not satisfied

2

Labour markets in crisis?

• European labour markets have become inflexible

• Many reformed: UK in the 1980s, Netherlands in early 1990s, Germany in 2002-2005

• Reforms are essential in Europe for competitiveness and adoption of new technologies

• Debt management and inflexible labour markets got confused with bad outcomes for each

3

Optimal Currency Area?

• OCA requires similar economic structures and business cycles to reduce the risk of different policy requirements

• The crisis exposed differences due mainly to relative size of construction sector and debt

• It requires labour and capital mobility to correct imbalances that may require different policies

• Although free, these don’t work as correction mechanisms

4

Optimal currency area

• Fiscal transfers can also offset imbalances, often recommended in addition to factor mobility

• But the Eurozone does not allow them – Maastricht criteria meant to remove the need for them

5

6

Fiscal transfers have been critical in countries where monetary union worked

• United States when West opened up: infrastructure was provided with East Coast money

• German unification: East Germany was kick-started with West German money

• In both cases we had political union!

• EZ is using them as the main tool to correct imbalances between members: ESM, various rescue packages, ECB QE

Are economies in the Eurozone similar to each other?

• Originally yes - Greece was probably the first country to be admitted with less similar structure (more agriculture, more trade with Balkans and East)

• But recent crisis exposed some unanticipated dissimilarities between members with bad consequences

• Ireland, Spain, Portugal and Cyprus grew very large construction sectors

• Smallest construction sector about 6% of employment before the crisis and majority below 8.5%. Greece at 8.8% but other “crisis” countries 10.7-13.3%

7

Construction employment shares, 2007 (in red: program countries)

NETSLV

GER

BELDEN

MAL

NOR

AUT

EURO ITA

GRE

CZECYP

LAT

SPA0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

8

Implications

• Crisis started in the housing sector – so countries with bigger construction sectors received a bigger shock

• Banks had over-extended loans in this sector; governments guaranteed them to avoid run on the banks

• So the negative impact of the housing shock in these countries was reinforced by public debt explosion that forced contractionary fiscal policy

9

Why no debt crisis in the Baltics and why in Greece?

• In the case of the two Baltic states their large construction sectors seemed to be justified by their large growth rates following transition

• In the case of Greece the problem was not so much the bursting of a construction bubble but a large public debt accumulation prior to crisis

10

Correlation between construction sector size and growth rates

0 1 2 3 4 5 6 7 8 9 1000

02

04

06

08

10

12

14

R² = 0.197477295735625

Average growth rate 2001-07

Co

nst

ruct

ion

sh

are

2007 CYP

EST

11

POR

SPA IRL

LAT

Correlation between construction sector size and growth rates

0 1 2 3 4 5 6 7 8 9 1000

02

04

06

08

10

12

14

R² = 0.3787432511015

Average growth rate 2001-07

Co

nst

ruct

ion

sh

are

2007 CYP

EST

12

LAT

Labour market responses

• With flexible exchange rates, when big negative shock hits a sector like construction demand for imports falls and exchange rate depreciates

• In a common currency area we need other corrections

• Out-migration

• Fiscal transfers

• Failing these “internal depreciation”, namely, wage reductions

13

Internal depreciation

• Forced on programme countries

• But unemployment needs to rise substantially to trigger the internal depreciation

• and it did, making the recession worse

14

Unemployment change 2007-2012

GE

MA AU

RO NO LU FR UK SK DE EU EZ LA IT LI CYG

R

-5

0

5

10

15

20

25

15

Did recession trigger the right labour market response?

• Nominal and real wages fell everywhere in the periphery but only in Greece to a non-trivial degree: 17% fall in real average earnings

• Although there was some deflation prices largely held up

16

Real average earnings 2012(2009=100)

own Relative to Germany

Ireland 97.0 94.2

Italy 97.9 94.0

Spain 96.8 95.1

Portugal 90.6 87.9

Greece 82.5 80.1

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Did wage adjustments bring the right results?

• Biggest failure of the combined programmes of debt reduction and economic restructuring

• Massive fiscal retrenchment was reinforced by real wage reductions that spilled out to the whole economy

• Classic Keynesian response of labour markets: negative fiscal multipliers reinforced instead of being offset by wage reductions

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Why didn’t wage reductions work?

• For standard Keynesian reasons: deflation does not get a country out of a recession, especially one with large debts

• Wage and pension reductions accompanied by a fall in government spending, tax rises and dysfunctional (home-biased) banks reduce aggregate demand catastrophically

• The real value of debt rises; the troika forces further spending cuts to reduce the debt to GDP ratio; deflation gets worse

• A vicious circle that leads to more debt and unemployment

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Labour markets at fault?

• Ireland has flexible labour markets: its aggregates are similar to other countries hit by the construction shock

• The key reason for Europe’s labour markets not working is the deflationary shock following the debt crisis

• Compare Ireland (flexible labour markets) with Spain (inflexible labour markets)

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GDP per head2007=100

2007 2008 2009 2010 2011 2012 201375

80

85

90

95

100

105

Ireland Spain

21

Employment rates2007=100

2007 2008 2009 2010 2011 2012 201375

80

85

90

95

100

105

110

Ireland Spain

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Monetary policy

• The obvious alternative to fiscal austerity is expansionary monetary policy

• The ECB needed to create more inflation that would depreciate the euro and reduce the real burden of the debt; err on the upside on its inflation target

• Bank of England followed similar policy when Coalition government imposed debt-reduction fiscal policies in 2010

• ECB eventually acted (March 2015)

23

Could the ECB balance them out?(Inflation target “just below” 2%)

December 2014 figures (all per cent)

Inflation unemployment

Germany 0.8 4.9

Southern periphery

-0.2 18.6

Eurozone 0.4 11.5

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ECB policies

• Given unemployment rates, correct monetary management of common currency area required erring on the upside, not the downside

• ECB tolerated 0.4% inflation with a target of just below 2%, it could have tolerated 3%

• Low debt countries had nothing to fear from it, high debt countries would have benefited

25

Debt burdens

• Debt burdens are tolerable now because of very low interest rates and help from IMF and ECB/Commission

• But when interest rates start to rise they will become unsustainable – inconsistent with fast growth

• Need to find a way of reducing the debt burden

• This inevitably will involve some kind of “haircut”

26

Investment and growth

• But more importantly, we need more investment and productivity growth

• Germany doing well in Europe – but the average EU performance is appalling

• Need to find a way of financing investments, e.g., draw distinction between money lent for investment and money lent to finance budget deficits

• Otherwise we will keep falling behind

27

Domestic R&D, 2012

EU-28 GERMANY USA JAPAN CHINA0

0.5

1

1.5

2

2.5

3

3.5

business government higher education

% o

f G

DP

Fixed capital formation, private

US EU Spain Portugal Ireland Greece0.0

5.0

10.0

15.0

20.0

25.0

30.0

2007 2012

% o

f G

DP

Fixed capital formation, public

US EU Spain Portugal Ireland Greece0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

2007 2012

% o

f G

DP

Labour markets

• Labour markets are not to blame NOW but don’t lose sight of the fact that monetary union requires flexible labour markets

• Many countries, especially in the South, still lack flexibility

• Recent structural reforms are in the right direction but they are taking time to have a positive impact and they need the cooperation of all social partners

31

German reforms

• The German reforms of 2002-05 tool place in favourable conditions and still had their impact 4 years later

• German officials point out that it was great help that rest of Europe was growing and they broke the Maastricht deficit criteria to help implement the reforms

• Exactly what Greece and the others are not allowed to do now!

32

Future of Europe

• Do the Eurozone countries have the political will to cooperate further to restore balance in economic performance?

• If not, future of Eurozone and EU bleak

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