The Euro – Past, Present and Future

Kurt HuebnerInstitute for European Studies at the

University of British Columbia

What Kind of Crisis Are We Talking About?

• Layers of crises• Crisis of financial capitalism• Financial crisis the mother of all crises• Peripheral debt crises as result of failed

regimes of accumulation• Eurozone architecture crisis• Political crisis

Melange

• History shows that financial crises can generate sovereign debt crises

• Sovereign debt crisis of eurozone economies kick-started by Greece…

• and replicated in Ireland, Portugal, Spain, Italy• …contagion fers abound

Endgame Phase: Refinancing Challenges Ahead

• Banks are international in life but national in death: Banking crisis ahead?

• Eurozone entered recession: reduction in GDP growth results in rise of debt ratio and thus aggravation of crisis

• Disconnect between political crisis management and financial market expectations

• Procrastination as crisis management mode• Refinancing needs as test dates• No private liquidity problem….• But trust problem• Loss of access to financial markets/unsustainable yield

Due Dates for Greek government bonds in billion Euro

2012 2013 2014 2015 2016 2017 2018 2019 2020 20210

10

20

30

40

50

60

70

80

44.6

27.931.8

22

15.8

71

30.625.7

5.30.5

Source: Der Spiegel (2011)

Due Dates Portuguese Government Bonds

2012 2013 2014 2015 2016 2017 2018 2019 2020 20210

10

20

30

24.7

10.8

15.9

11.910.2

7.1 7.18.8 9.3

18.8

Due Dates Spanish Government Bonds

2012 2013 2014 2015 2016 2017 2018 2019 2020 20210

50

100

150 142.2

83.276.5

46.8 46.5

34.2

17.3

32.4 34.3

23.6

Due Dates Italian Government Bonds

2012 2013 2014 2015 2016 2017 2018 2019 2020 20210

50

100

150

200

250

300

350319.6

157

124.2140.9

82.5 87.763

89.773.8

89.9

Due Dates French Government Bonds

2012 2013 2014 2015 2016 2017 2018 2019 2020 20210

50

100

150

200

250

300

264.4

126.3

97.1113.7

103.8

71.6

47.1

69.679

55.3

Due Dates German Government Bonds

2012 2013 2014 2015 2016 2017 2018 2019 2020 20210

50

100

150

200

250

300276.1

192.2

118.4104.8

118.7

39.1 47.5 48

7557.3

What do such figures tell us?• Not very much in ‘normal times’ as government bonds are

seen as secure/boring• Very much in troubled times: Risk evaluation changes and

financial markets tend to overshoot• Public debt ratio depends from nominal annual GDP growth

rate, nominal interest rate and the primary public budget change. If an economy, like Italy, has a debt ratio of 120% and let us say a growth rate of GDP of 1 % and a nominal refinancing rate of 5%, then the primary budget just show a surplus of 4% in order to keep the debt ratio constant

• So, what is the crisis all about?

Challenges

• Avoiding insolvency and thus avoiding banking crisis

• Dealing with self-fulfilling prophecies• Keeping access to financial markets…• ..to reasonable conditions• Stimulating economic growth• Reshaping the political architecture of the Euro• Creating reasonable convergence/divergence

‘Euro: Failed Project?’

• Majority of North American economists warned early on, even though with varying and mostly falsified reasons

• Markets seemed convinced of the Euro and promoted it to the second international reserve currency

• Strong appreciation against shaken US-Dollar• …and then things changed dramatically

Construction Flaws of the Euro

• Narrow mandate of the ECB

• Full-fledged liberalization project without EU-wide mode of regulation

• National regulatory bodies and EU-wide financial markets

• Flawed SGP

• Missing exit rules• Missing bankruptcy

rules• Missing fiscal union

with taxation power• Reliance on monetary

convergence indicators..• Missing

competitiveness issues

Incentive Misalignment• Average rates Germany Spain Greece 1999-2007• Nominal i-rate 3.8% 3.9% 4.4%

• Inflation rate 1.8% 3.3% 3.5%

• Real i-rate 2.o% 0.6% 0.9%

• Savings incentive in Germany; savings surplus generate capital outflow: S > I, thus CA surplus

• Easy and cheap funding of public budget deficits. • Inflation gap also made private credits relatively cheap

Original Sin

• Governments issue bonds in a currency which they have no control over

• Control sits with the ECB: loss of exchange rate tool and autonomous interest rate policy

• In case of problems governments are running into bad equilibria: Debt ratio unsustainable increase of risk premium austerity reduction of growth rate debt unsustainability self-fulfilling prophecy

Fundamentals and Financial Market Responses

• UK –Spain comparison: Not all crises are equal…

• Bank of England a different institution than ECB

• Bank exposure

Example: UK-Spain

,,,

Policy Implications

• ΔS = (r – g)D , where S is the primary budget surplus, r is the nominal interest rate on the government debt, g is the nominal growth rate of the economy and D is the government debt to GDP ratio

• Spain needs a much higher primary budget surplus!

• Spain pays the price for original sin

Crises

• Not all crises are equal• Financialization crises in

Ireland, UK, and US

• Soft budget constraint crises in Greece, Italy, Portugal

• Competitiveness crises in Greece, Spain, Portugal, and partially in Italy, France and Belgium

• Clientelist states in Greece and Italy

Divergence Reigns

Surplus current account economies:Germany, Scandinavia,(Netherlands, Luxembourg)Relatively strong fiscal positionsRelatively good labor market performance

• Deficit current account economies:

• Greece, Portugal, Spain, Italy

• Weak fiscal positions• Weak labor market

performance • Weak competitiveness

Crisis Management

• Treating the crisis as purely a public debt crisis....is not meeting the challenges:

• ‘Instead, it (EU crisis management) focuses on what we consider to be a one-sided approach by emphasizing fiscal austerity without a strong and consistent program to raise the growth potential of the economies of the eurozone’….

….

• We also believe that the agreement (EU December accord) is predicated on only partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery…In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness…’

Paradox of Thrift

• Austerity meets the paradox of thrift (Greece, Ireland, UK…)

• EFSF + ESM : Big enough?• The implications of losing triple A rating:

France and Austria out…loss in trust may play out badly in case expectations turn sour again

Small Bazookas billion Euro

Eu-ro-

pean Fi-

nan-cial

Stabil-ity

Facil-ity

(EFSF) 440

IWF 250

Guaranteed byEU budget60

France126.4

Italy111.1

Spain73.8

Netherlands 35.4Bel-

gium21.6

Greece17.5

Austria17.3

Por-tugal15.6

Finland11.1

other EU

countries22.2

Ger-many168.3

August 2011: Euro-Rescue-Mechanismup to 750 bn. Euro (ends 2013)

2013: European Stability Mechanism (ESM): capital/securitiesaround 620 bn. Euro

EU Member states increased

the Funds’ volume to

440 bn Euro

Political Constraints

• Eurobonds of some form would add an alternative to US Treasury and potentially attract funds

• Yet, German government opposes, and so does the German Supreme Court

• Alternatives are designed but currently politically not feasible

ECB as Stealth Saviour

• ECB a unique central bank due to its foundation treaty

• Highly contested institution• Stealth actor in regards to quantitative easing• Lender of last resort in a emergency kind of

way

Balance Sheet

Scenarios

• Eurozone stays intact and gets austerity injections: Weak growth, high unemployment, retrench of the welfare state; loss of reserve currency status…

• Greece leaves: Strong depreciation of new/old Greek currency; exclusion from international capital markets; insolvency; bank runs; contagion speculation; pressure on ‘weak candidates’…

• Germany and likeminded economies leave: Strong appreciation of the currency; negative effects on price competitiveness; factual split of EU; market size shrinks…