The Baltics and the euro

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Presentation by Giancarlo Corsetti, Professor of Macroeconomics, University of Cambridge at International Conference: "Against the Odds: Lessons from the Recovery in the Baltics" organized by the International Monetary Fund and the Bank of Latvia. Riga, June 5, 2012

Transcript of The Baltics and the euro

Slide 1

The Baltics and the euro

Giancarlo Corsetti

Against the odds: Lessons From the Recovery in The Baltics

Riga, Latvia, June 5 2012

Faculty of Economics NIAS Duisenberg Fellowship


A policy strategy pursuing integration in the euro area raises two


What kind of union are the Baltic countries joining?

How does/will the euro zone cope with macroeconomic and financial stability at systemic level?

How can a small open economy prosper in (and contribute to) a large monetary and economic union (currently in a crisis)?

A forward-looking assessment of the recent Baltic experience

Good-bye currency risk, hallo sovereign risk








Long-run government bond yields in Europe 1987-2012











1992-93 crisis






From currency to sovereign/jurisdiction risk

1990s: imperfectly credible fixed exchange rates created vulnerability to

confidence (self-fulfilling) crises.

By eliminating currencies, the euro was expected to stem financial instability in Europe.

Today: sovereign replaces currency risk as source of vulnerability to

confidence crisis.

By eliminating domestic debt markets the argument goes -- some form of eurobonds will reduce instability.

But weak fundamentals and confidence feed on each other.

Eliminating markets may reduce room for confidence crises, but does not rule out the emergence of imbalances.

A systemic and a country-specific challenge

Monetary union works if it can rely on institutions/policies that

(a) contain the emergence of imbalances and

(b) if imbalances materialize, can foster adjustment.

This is the key challenge for the euro area as a whole.

For the Baltic countries, the challenge is obvious:

In or towards the euro, they reap the gains from eliminating currency risk.

The policy priority is to prevent/contain sovereign/jurisdiction risk

But there is also a new responsibility: working cooperatively with the rest of the union

Sovereign risk undermines macroeconomic stability

Negative expected output


Increase in public debt

Higher sovereign risk

Higher private borrowing cost

Banking fragility

Lower demand

Preventing/breaking this

diabolic loop is a common objective

in a currency union

The crisis of the euro: past and present

Beyond the current crisis, Europe suffered at least one other large

systemic monetary break up:

the crash of the Exchange Rate Mechanism (the hard ERM) in 1992-93, followed by a period of speculative waves and currency and financial


How does a euro crisis develop?

In 1992-93, as today, the crisis developed in 3 phases

(a)Imbalances may build up for different reasons (financial, fiscal, policy)

market signals are socially-inefficient (underestimated risk) result in large price misalignments (eroding competitiveness) typically exacerbated by a dollar slide (1992 and 2009) yet remain long underestimated (no early action is undertaken)

(b)A large shock (German unification, the global financial crisis) makes

them unsustainable

(c)A policy conflict divides the Center from the Periphery (worsened by

faltering political support for a common currency)

The policy conflict in 1992-93

German unification caused domestic overheating requiring the D-mark to

appreciate in real terms. This was possible via either:

(a) Increase in German inflation

ruled out by the Bundesbank, which hiked policy rates and thus generated a contractionary shock for the rest of the system

(b) Exchange rate realignment

ruled out by countries, investing their political capital on maintaining a fixed exchange rate

(c) Deflation in the rest of the system

painful, with uncertain political consensus.


Crisis erupts as cooperation grounds to a halt

In 1992, proposals for a coordinated adjustment: small D-mark re-valuation, matched by small devaluation of weak currencies


Equilibrium vastly different without policy coordination: fewer countries expected to devalue by more than in the proposed cooperative solution.

Speculation sky-rocketed when agents realized they were playing against countries in conflict with each other.

Then, as now, the crisis was first and foremost a manifestation of (a break down of) ineffective intra-European cooperation

The story is in Buiter Corsetti Pesenti 1998


Relative to todays crisis, in 1992-93:

(a) Exchange rates could/did adjust

low pass through, moderate inflation export growth helped by German demand and global recovery

(b) While no cross-border payment system provided automatic cross-

border financing:

Sudden stops of private capital forced depreciation, unless other countries provided large discretionary support

(c) debt in crisis countries was denominated in domestic currency

Relative to todays crisis, in 1992-93:

(d) While countries undertook deep fiscal adjustment, their efforts were

fostered by moderate inflation (5%) over a few years.

E.g. in addition to a large budget cut (5.8% of GDP) in 1993, Italy produced large public saving by freezing part of nominal spending

over the following years

But here comes a crucial element

(e) New policy models replaced disinflation through exchange rate stabilization and provided a sense of direction:

Inflation targeting, embraced by the UK and SWE.

Monetary unification.

The end of the crisis in 1995

It took a couple of years of policy adjustment, with trials and errors, for

Europe to restore credibility of full cooperation (Madrid summit)

markets then to settle on new equilibrium relative prices.

Yes, some banks had to be rescued

Then, the euro was launched effectively under the presumption that no

fundamental imbalance would ever materialize.

Todays crisis

Striking analogies in the development of the crisis.

But the euro

rules out (a) exchange rate adjustment;

softens (b) balance of payment constraint;

but also kills (c): debt is no longer denominated in domestic currency;

Undermines the possibility of a role for moderate inflation in fiscal or relative price adjustment

Todays crisis

Years into the crisis, still need to define a sense of direction

The fiscal compact is only one element

Hard to see any crisis resolution without strong cooperation in banking (recapitalization, deposit insurance) and public debt

management (sinking fund or some form of eurobonds)

The prospects for a solid/effective agreement on banking and sovereign

debt, however, also depends on resolving the real side of imbalances.

Uncertainty about the model of adjustment

How would adjustment via exchange rates work?

3 main channels:

1. Relative price of tradables/nontradables


2. Relative national wealth

Domestic demand and net savings (transfer problem)

3. World price of domestic liabilities

In domestic currency: portfolio view (Kouri, Tobin)

In foreign currency: balanced sheet and valuation effects

How would adjustment via exchange rates work?

1. Relative price of tradables/nontradables rises in the short run

Quickly setting incentive to reallocate resources towards exports and domestic production.

2. Relative national wealth falls

Reducing demand and imports for a given level of output. Composition/diversification of national portfolios matter

3. World price of domestic debt denominated in home currency falls

In response to a rise in sovereign risk, the exchange rate instantly adjusts the international price of bonds for a given nominal interest

rate --- see the recent UK experience in this light.

A realistic view

The third (risk-pricing) channel is not operative in countries that borrow in a non-national currency.

With a large debt in a foreign currency, however, real depreciation raises automatically its burden whether it occurs via a fall in prices

and wages, or via the exchange rate

Primary and external surpluses need to respond flexibly to shocks (e.g. banking crises) and fluctuations in the market perception of risk

With the exchange rate, non-tradable prices falls more rapidly (arguably causing output to contract by less)

The hard truth: in the euro area, some form of fiscal devaluation is the only instrument left.

The Baltic experiment

Front-loaded deep (fiscal) adjustment can force a quick turnaround of

market sentiments, and reduce vulnerability over time.

Special conditions eg:

Low initial public debt

But large private debt in foreign currency

Large financial support by in