heise - emerging from the euro debt crisis (2013)

From this perspective, the currency is an impediment to rather than a catalyst of further Euro-pean integration as it creates political conflicts between the European partners, with some

Emerging from the Euro Debt Crisis

Closing Date: May 2013

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Michael Heise

Allianz SE

Munich, Germany

The crisis has changed Europe’s mindset Since the Second World War European integration knew only one direction, the widely ac-cepted aim was an “ever closer union” For sure, the process did not always follow a straight line, but no one seriously doubted the finality

of the European project The Greek drama and the subsequent moil on Europe’s financial markets threw this European belief into disarray Suddenly, disintegration became a real and present threat; a relapse into particularistic and nationalized European politics was no longer unthinkable

tur-But it was a necessary wake-up call After the establishment of the monetary union and the successful enlargement to the East, Europe became a little self-complacent The integration process was more and more seen as a project of the elites, the technicalities of which were discussed by the experts in “Spaceship Brussels” The people of Europe did not bother to think too much about Europe and its future Somehow, the European project and its narrative about peace and rec-onciliation seemed to be stuck in the 20th century What a difference

a crisis can make

At last, we have the necessary and intense public debate about ropean integration and the path ahead Even decisions by the German constitutional court about fairly obscure paragraphs of the treaty are suddenly top news and discussed widely by the public And there is a growing number of articles and books jumping on the euro bandwag-

Eu-on This book by Michael Heise, that is based on his work as Allianz’s chief economist, is no exception But it differs by trying to bridge the gulf between academic analysis and practical recommendations that play a role for corporate decision making

Foreword

The future of the euro is essential for the political and economic landscape on our continent for the years to come The currency is the touchstone of how Europe will succeed in defining its place in the 21st century The global sea is getting rougher: the emergence of new powers, the ageing of our societies and climate change pose formi-dable challenges To keep the European dream alive—which is not only about raising prosperity but maybe even more about sustainabil-ity, social justice and diversity—Europe as a whole has to find new ways of joint decision making and shared responsibilities Otherwise, Europe will cease to be a voice that is heard in tomorrow’s world economic and political order And without international relevance and influence, slow but steady decline seems inevitable Of course, the euro does not automatically bring us closer to the goal of a political and fiscal union But it has triggered intensified political efforts on this long and probably arduous journey But as the saying goes, every journey starts with a single step, and that has been undertaken

Michael Diekmann

Foreword

The ideas and conclusions in this publication are based on many years

of ongoing research at the Economic Research and Corporate opment department of Allianz SE in Munich, Frankfurt and London Many colleagues have given their input to this work First of all I would like to thank Anna Sophia Winter and Laura Pütz who worked

Devel-as interns in my department over the pDevel-ast few months and Devel-assisted me very ably in the necessary research and the development of charts and tables Teresa Schill and Maximilian Müller deserve a special men-tion as they helped to draft some paragraphs of the text and assisted

in the co-ordination of the project along with my personal assistant Bianca Mittermeier I have also benefited greatly from discussions with my colleagues at Allianz Economic Research I thank all of them and would like to highlight the support provided by Ann-Katrin Pe-tersen, Dr Arne Holzhausen and Dr Rolf Schneider as well as the excellent editing by Alexander John Maisner A special thanks goes

to Prof Dr Paul J J Welfens, Wuppertal for valuable comments and suggestions Any mistakes are my own responsibility

Various aspects of the topic have also been dealt with in a series

of lectures and seminars that I have held at Johann-Wolfgang Goethe University Frankfurt in cooperation with Prof Dr Beatrice Weder di Mauro, Mainz, and Prof Dr Rainer Klump, Frankfurt since the crisis took shape in 2007/2008 The book explores some of the technical and theoretical issues in a hopefully easy manner and it addresses readers who are interested not only in the policy conclusions but also

in the basic economics at work This is essential in order to bring some clarity to the mass of conflicting arguments put forward in the public discussion While in some chapters the book does quote quite

a few recent publications on the relevant issues, it does not offer a comprehensive overview of the extensive literature that has been pub-

Preface

lished on the economics of European integration and the recent debt crisis The book is written from the point of view of a business econo-mist who assists corporate decision making and not from a primarily academic perspective

Preface

Contents

1 Introduction: Managing Complexity 1

2 The Path to European Monetary Union 5

References 16

3 The Evolution of the Debt Crisis 17

References 22

4 Economic Impact of the Euro—Who Benefits? 23

4.1 A Global Currency Emerges 24

4.2 Low Inflation in the Eurozone 26

4.3 Impact on Growth Inconclusive 27

4.4 Intensification of Intra-EMU Trade and Capital Flows 30 4.5 Advantages for German Exports in Times of Reform 32

References 34

5 Re-assessing the Criteria for an Optimum Currency Area in Europe 35

5.1 Asymmetric Shocks and Adjustment Options 36

5.2 Openness of the Economy and Diversity of its Trade Sector 37

5.3 Wage Flexibility and Labour Mobility 40

5.4 Capital Mobility 43

5.5 Financial Market Integration 45

5.6 Coherence in the Perception of Economic Policy 48

References 49

6 What Went Wrong with Public Debt and Macroeconomic Stabilization? 51

6.1 A Toothless Stability Pact 52

6.2 The Danger of Macroeconomic Imbalances 57

References 65

x Contents

7 Policy Conclusions 67

7.1 Escaping the Debt Trap—Balancing Austerity and Growth 68

7.1.1 Balancing Consolidation and Growth- Oriented Reform 68

7.1.2 Many Countries Have Successfully Done It: Consolidation Plus Reform 71

7.1.3 Debt Scenarios for The Future 76

7.1.4 Base Scenario: “Spending Discipline, Slow Reduction in Risk Premiums, Moderate Economic Growth” 79

7.1.5 Risk Scenario: “Insufficient Consolidation Efforts, Weaker Economic Growth” 80

7.1.6 Positive Scenario: “Spending Discipline, Stronger Economic Growth” 80

7.1.7 The Scenario Analysis Shows: Reversing The Debt Momentum is Not an Insurmountable Task 81

7.2 Counteracting Macroeconomic Imbalances 81

7.3 The Euro 2023: A Narrative 85

7.3.1 Institutional Changes and Different Speeds of Integration 88

7.3.2 Fiscal Guidance: Controls With Teeth 91

7.3.3 Macroeconomic Surveillance, Banking Supervision and Structural Reform Incentives 93

References 95

8 Aligning Crisis Management and Long-Term Reform Incentives 97

8.1 A Framework Conducive for Long-Term Investments 98

8.2 The Mutualisation of Debt In the Eurozone 102

8.3 The Learning Curve In Crisis Management 106

8.4 Devising the Right Instruments—A Brief Comparison of Alternative Solutions 108

8.5 Why Not Transform the Eurozone? 112

References 115

9 A Final Word 117

References 119

Index 121

Abbreviations

et al et alia

Euratom European Atomic Energy Community

Abbreviations

SUERF Société Universitaire Européenne de Recherches

Despite the impressive rebound seen on European financial markets following Mario Draghi’s famous speech in late July 2012, European leaders still face formidable challenges The restoration of some con-fidence on financial markets should not conceal the long-term chal-lenges to make the European Monetary Union function better in future and to make it more resilient to shocks Despite somewhat weaker headwinds for government borrowing, the situation remains highly complex Fiscal sustainability has not been restored in a number of countries as the consolidation of fiscal deficits is being hampered by recession or very weak growth Some reforms to restore economic competitiveness have been enacted, but more needs to be done As unemployment has risen markedly in most countries and even ex-ceeds 25 % in Spain and Greece, any changes in labour regulations or social security entitlements will continue to provoke demonstrations

on the street and will support the more radical political movements

in the countries concerned Beside these problems in their respective home countries, EU leaders also need to restore confidence in the ca-pability of the EU and the EMU to take the necessary steps to prevent such crises from re-occurring Cohesion in the Union of 27 countries seems at risk National interests are diverging and the UK is even discussing an exit In the eurozone, the countries that are expected to foot the bill or at least assume the fiscal risks of their partners are in confrontation with those countries receiving support and, sometimes loudly, sometimes quietly, calling for more solidarity There are big differences in political views concerning the right balance between austerity and growth: How much bitter medicine in terms of public savings or wage restraint is necessary to become healthy again? And how much burden will the taxpayers take without intervening against

M Heise, Emerging from the Euro Debt Crisis,

European integration? Given this complexity, it is not surprising that the polarity of views is increasing and that the whole euro project has been called into question

The crisis has certainly increased the number of critics who reject the common currency in its present form, and see it as an impedi-ment—a straitjacket—for countries trying to improve their competi-tiveness in order to get growth going again From this perspective, the currency is an impediment to rather than a catalyst of further Euro-pean integration as it creates political conflicts between the European partners, with some countries—take Greece—complaining about ex-cessive external influence and others—take Germany—rejecting the mutualisation of debt created by imprudent spending policies in other countries This camp argues that the euro is not the raison d’être be-hind Europe and recommends at least a significant restructuring of the Monetary Union or even a halt to the “dangerous” experiment of one currency for many different sovereign nations

This book will take a different route It is true, there are potentially harmful conflicts of interest, but they need to be overcome A dissolu-tion of the euro is no solution It would create horrific economic and political costs and would destroy decades of efforts towards integra-tion and co-operation in the community There would be a renational-ization of policies A major world currency would disappear and the countries behind it would further lose influence on the rapidly chang-ing world order with new political and economic powers emerging

No one—least so the United States and China—is waiting for 27 EU countries with a multitude of currencies and opinions to make their calls for the further development of global governance

Further economic and political integration is pivotal for securing Europe’s role in the global marketplace European integration must be based on public consensus and political debate Saving the euro is not

in itself an argument for further integration But the truth is that the experience of a crisis can trigger some steps that would have been un-thinkable in the past It can result in a leap towards stronger fiscal co-operation, more joint decision making on an EU level and an appro-priate reform of political institutions Policymakers have taken some steps in this direction at a series of EU summits in recent months But there are other bigger opportunities that should not be missed In the course of further integration the conditions for a well- functioning common currency in Europe need to be established Today, it is widely

1 Introduction: Managing Complexity

1 Introduction: Managing Complexity

acknowledged that some important elements of an “optimum

curren-cy union” have been missing since the euro was introduced in 1999 Particularly, there must be clear and enforceable rules for fiscal and economic policy co-operation and member countries must accept their responsibility for fiscal sustainability and macroeconomic stability.This book will start with a review of the necessary elements of a currency union and highlight the reasons why the system has run into its present troubles

It intends to point to:

• Achievements and failures of the currency union (Chap 4),

• Important policy recommendations to be drawn from a structural analysis of the currency union (Chap 5),

• Ways to improve fiscal sustainability and a stable macroeconomic performance of the union (Chaps 6 and 7),

countries on the 1st of January 1999, the euro has become the

offi-cial currency for 330 million people and the GDP of today’s

17-coun-try eurozone adds up to almost EUR 9.5 trillion (2012), ranking

sec-ond behind the United States As a project of monetary integration,

the euro is without historical precedent Its governance is complex

and unique Its evolution is embedded in the history of Europe While

many early proposals for a common European currency were fuelled

by the idea of political unity, the first concrete steps towards the

Mon-etary Union actually had the economic objective to limit exchange

rate fluctuations and to stabilize monetary relations This became all

the more important after the end of the fixed exchange rate system

of Bretton Woods and the large swings of the US dollar on exchange

markets This chapter examines very briefly how the idea of a single

currency was born and what steps led to today’s euro (Fig. 2.1) 1

As can be seen on the websites of the EU Commission, an early tion of a single European currency dates back as far as 1929 It was Gustav Stresemann, then foreign minister of Germany, who put the following question to the League of Nations on the 9th of September 1929: “Where are the European currency and the European stamp that

about the frontiers that had been created through the Treaty of Versailles and that these impeded easy travel and trade across Euro-

1 For thorough and comprehensive historical analyses see: James ( 2012 ) and Marsh ( 2009 ) Additional information can also be found in: Baldwin and Wyplosz ( 2009 ) and European Union, EU ( 1995–2012 ).

6 2 The Path to European Monetary Union

8 2 The Path to European Monetary Union

pean borders While these words and ideas were exceptionally nary for the time Europe was set to see its darkest chapter only a few years after Stresemann had delivered this speech However, the tragedy of the Second World War ultimately led to the foundation of three European institutions, which would later evolve into the Euro-pean Union and pave the way for the creation of the euro Six coun-tries—Belgium, France, Germany, Italy, Luxembourg and the Nether-lands—established the European Coal and Steel Community (ECSC)

visio-on the 18th of April 1951 In March 1957, the Rome Treaties between these countries laid the foundation for the creation of the “European Economic Community” (EEC) and the “European Atomic Energy Community” (Euratom) Due to the existence of the Bretton Woods System, monetary coordination was at first not the focus of the EEC, but rather emerged as an idea when the Bretton Woods System began

to fall apart at the seams Efforts to promote monetary integration can

be broken down into three broad attempts These provide a guideline for understanding the course of events:

• The first attempt was initiated by the Barre Report in 1969, aimed at achieving an Economic and Monetary Union While this first initia-tive failed, it marks the beginning of efforts towards monetary and economic integration and provided lessons for subsequent attempts

• The second attempt followed in 1979 with the creation of the ropean Monetary System (EMS) and the European Currency Unit (ECU)

Eu-• The third attempt, which would later lead to the introduction of the euro, was started by the “report on EMU in the European Com-munity” by the Delors Committee in 1989 (European Commission

2012b)

Before these attempts, the European Council had in 1964 decided that central banks of the Member States of the EEC should cooperate, es-pecially in the field of international monetary relations and that Mem-ber States should consult prior to changes in exchange-rate parities

At the December 1969 summit in The Hague, the Heads of State and Government agreed on the basis of the Barre report upon a new ob-jective of European integration, namely an Economic and Monetary Union (EMU) They assigned a group, headed by Pierre Werner, the Prime Minister of Luxembourg, with the task of drafting a report on how to achieve this by 1980 The reasons for the EEC countries to seek monetary stability and monetary cooperation were manifold For

2 The Path to European Monetary Union

relatively small and open European economies, the exchange rate was

an important variable, since highly volatile nominal exchange rates created negative effects on trade and investments in the form of high uncertainty and hedging costs As intra-European trade relations be-came stronger, exchange rate volatility was seen as a barrier to trade and made it difficult to handle integrated value chains The Bretton Woods System of dollar pegs ran into trouble in the late 1960s and the European countries were keen to become more independent from monetary policies in the United States The continuous devaluation

of the dollar and expansionary policies to finance the Vietnam War increasingly conflicted with European interests For these reasons, the Member States of the EEC considered the creation of a monetary zone as a viable option to achieve more monetary independence and stability

In its final report, submitted in October 1970, the so-called “Werner Group” set out a plan to achieve the targeted economic and monetary union in stages by 1980 While the adoption of a single European cur-rency was seen as a long-term outcome of the process, primary goals were the complete liberalisation of capital movements, the full con-vertibility of countries’ currencies and the fixing of exchange rates In order to achieve these targets, the Werner Group called on Member States to improve economic policy coordination and to draft rules for national budgets The Member States approved the recommended ac-tions by the Werner Group, but willingness to follow through with concrete steps was wanting The Werner Plan finally collapsed under the financial turmoil that was about to set in In August 1971, the United States unilaterally closed the gold window and announced the dollar’s non-convertibility with respect to gold The resulting devalu-ation inflicted losses on US dollar holders and the final breakdown

of the Bretton Woods system in 1973 disrupted plans for monetary union in Europe This tremendous change in the exchange rate system caused instability on foreign exchange markets and put severe stress

on the parities between the European currencies Rising oil prices added further pressure and triggered a broad range of different policy responses by the member countries

In March 1972, the six founding members of the EEC had decided to collaborate in order to stabilize exchange rates by creating the “snake

in the tunnel” and establishing the European Monetary Cooperation Fund (EMCF) in 1973 The “snake in the tunnel” mechanism was

2 The Path to European Monetary Union

designed to have Member States’ currencies float within a certain range against the dollar It pegged the EEC currencies against each other and was intended to stabilize inner-European trade relations It was joined by the newly acceded member countries United Kingdom, Denmark and Ireland The “tunnel” defined specific margins of fluctuation against the dollar, while the “snake” was the managed floating of the currencies around the dollar within these margins The prevailing weakness of the dollar, different approaches in eco-nomic policy by the member countries and the oil crisis soon led to the demise of this scheme and the exit of nearly all members within

2 years It was the lack of monetary discipline and the preference for stimulating growth and employment that made countries join and leave the Economic Monetary System, whichever they regarded as more valuable in each situation France, for example, left the system twice—in 1974 and again in 1976 after it had temporarily rejoined Italy and Sweden also preferred to go their own ways Since even the first stage could not be completed successfully, the second and third stages of the Werner Plan had died While first the “tunnel” had faded due to the free floating of the dollar after the abolition of the gold standard in 1971, the “snake” did not survive either as Member States did not stick to it The consequence was a currency area with the Ger-man “mark” as anchor currency and especially smaller countries (like Denmark and the Benelux) following the monetary policy of the Ger-man Bundesbank, which had proven its independence from political interests and its monetary stability credentials

Initiated by France and Germany in the persons of Giscard d’Estaing and Helmut Schmidt, the second attempt to finally cre-ate an economic and monetary union with stable exchange rates was launched in March 1979 with the creation of the European Monetary System (EMS) The European Council had agreed upon the broad outlines of the EMS in July 1978 and decided that it should com-prise all the currencies of the EEC and that it should be based on a European Currency Unit (ECU) as a pillar of the system Further-more, the new set-up foresaw fixed, but adjustable exchange rates with rules that should be at least as strict as the “snake” While it was also designed to create and maintain monetary stability, it ad-ditionally aimed at achieving closer economic convergence between Member States Except for the UK, all the Member States partici-pated The ECU was created to serve as a benchmark for calcula-

2 The Path to European Monetary Union

tions of exchange rates for a newly created credit mechanism tween the Member States and it was intended to replace the German mark at least symbolically as the political currency of Europe The ECU itself was a weighted average of the participating currencies, with the mark initially accounting for 33 % and the franc for 20 %

be-of this virtual basket currency Currencies were allowed to fluctuate within a margin of 2.25 % to either side of bilateral rates based on the calculation of the ECU Italy was given a margin of 6 % Intervention rules were based on these bilateral rates, not on the central parities

to the ECU The system soon came under stress, when the second oil price shock in 1979 created upward pressure on inflation and led

to restrictive policy moves by the Deutsche Bundesbank, which all other EMS members more or less had to follow in order to keep their exchange rates within the narrow bands The increasing tensions led

to numerous exchange rate adjustments in the years up to the early 1990s Despite these problems, the creation of the EMS can be seen

as the turning point in European monetary integration

Parallel to closer monetary integration, the EU Council adopted the Single Market Programme in 1985 and the Single European Act 1987, under which a market without internal frontiers was to be completed

by 1992 In June 1988, the European Council passed a directive for the complete liberalization of capital movements and committed to the target of a step-wise realisation of the economic and monetary union It assigned a committee comprising the governors of the na-tional central banks and Jacques Delors—then president of the Euro-pean Commission—as chair with the task of analysing and suggesting concrete steps towards the realization of such a union The result-ing “Delors Report” proposed an economic and monetary integration

in three stages It was publicly released in April 1989 and accepted

by the Madrid European Council in June 1989 This is important, as Germany’s agreement to the euro is often said to have been the price for German unity paid by the Kohl government Actually at the time

of the Delors report, the possibility of reunification was not yet seeable, so the argument has been rejected by many policymakers of that time But on the other hand, the international treaties for the euro had to be worked out in the years following the Delors report and the German position in these negotiations was certainly influenced

fore-by reunification The creation of the euro was a signal to all partners that the reunified Germany—sacrificing its D-mark, a symbol of eco-

2 The Path to European Monetary Union

at the latest in 1999 Participation in the final process of introducing the currency required among other things compliance with two criteria for budget stability: budget deficits were not to exceed 3 % of GDP even in periods of weak economic activity and public debt was not

to exceed the threshold of 60 % of GDP Further convergence criteria asked for inflation rates of at maximum 1.5 % points higher than the average of the three most stable countries, long-term interest rates not more than 2 % above the average of the three lowest interest-rate coun-tries and for no tensions in the exchange rate mechanism for at least 2 years before the introduction of the common currency

Before the second stage could begin, however, the new rate mechanism (ERM) and the European Monetary System had to weather a further crisis in 1992 The repercussions of German reunifi-cation and high German interest rates destabilized the ERM, since the restrictive monetary policy of the German Bundesbank was not suited for the other member countries Italy was grappling with declining economic activity as well as fiscal problems and by mid-September

exchange-1992 it had become clear that the current parity of the lira was no longer sustainable On September 13th, the Italian lira was devalued

by 7 % However, the lira immediately reached its new ERM floor again the next day, while the British pound also came under increased

2 The Path to European Monetary Union

stress due to mounting speculation On September 16th, subsequently known as Black Wednesday, the British pound fell below its lower ERM bound and consequently the Bank of England announced ster-ling’s withdrawal from the ERM On the same day, Italy decided not

to intervene anymore and left the ERM The crisis exposed the nerability of the ERM and later on resulted in the adoption of a new adjusted exchange-rate mechanism (ERM II) and the widening of in-tervention bands to 15 %

vul-During the second stage from 1994 to 1998, the European tary Institute (EMI) inherited the tasks from the former EMCF and the Committee of Governors It was responsible for enabling and strength-ening cooperation among national central banks and coordination of monetary policies, but had no monetary competencies of its own Basi-cally, it was supposed to build the foundations for the implementation

Mone-of a common monetary policy, targeting price stability and the creation

of a single currency later during the third stage Converging economic policies were one essential step towards achieving this goal Further-more, the national central banks had to become independent before stage three could begin In December 1995 the EMI decided to name the single currency “euro”, which was to be introduced with the onset

of the third stage on January 1st 1999 As early as in December 1996 it presented to the public the designs for the euro notes, which would be brought into circulation on January the 1st, 2002

At the Madrid Council meeting in 1995 the decision was taken

to enter into the third stage with irrevocably fixed exchange rates in

1999 German demands were accepted to supplement the Maastricht treaty with a Stability and Growth Pact which was then drafted and eventually passed in June 1997 It was designed to ensure fiscal disci-pline in the economic and monetary union’s Member States The pact was amended and finally ratified in May 1998 However, as early as

in February 1996, the European Parliament had decided that “in the case of an excessive deficit of a Member State (…) the general eco-nomic position must be taken into account”, making the 3 % rule more flexible, but also susceptible to arbitrariness (European Commission

2012c) This was an early sign that the Stability and Growth Pact might prove not to be as effective as intended (see Sect 6.1)

On May 2nd 1998 the Council of the European Union announced that eleven Member States fulfilled the requirements for participation

in the third stage and thus, for the introduction of the common

cur-2 The Path to European Monetary Union

2 The Path to European Monetary Union

rency on January 1st 1999 These eleven countries comprised Austria, Belgium, Finland, France, Germany, Luxembourg, Ireland, Italy, the Netherlands, Spain and Portugal For this decision, the 60 % debt cri-terion had to be interpreted very flexibly in the sense that countries above the threshold could still comply if they showed at least clear progress towards reaching lower debt levels Otherwise, Austria, Bel-gium, Ireland, Italy, the Netherlands, Portugal and Spain would have failed to meet the entry conditions Germany was also slightly above the 60 % threshold in 1997, the benchmark year The finance minis-ters of the respective member countries together with the heads of the national central banks then determined that the bilateral exchange rates of May 1998 would be used for the final conversion rates for the euro With the appointment of the president, the vice president and the four additional members of the ECB Executive Board, the ECB was officially founded on June 1st 1998 Since then, the ECB and the national central banks constitute the Eurosystem, which formulates and determines the common monetary policy

January 1st 1999, with its irrevocable determination of the official exchange rates of the former national currencies and the implementa-tion of a single monetary policy by the ECB, marks the official start

of the third and last stage of the process towards the Economic and Monetary Union The rules on budgetary policy became binding and any Member State falling foul of them would, in theory, be penalized.Before the new currency was finally handed out physically to the people on January 1st 2002, Greece joined the eurozone in 2001, so the eurozone comprised 12 Member States when the first euro notes and coins were distributed Since then, Slovenia in 2007, Cyprus and Malta in 2008, Slovakia in 2009 and Estonia in 2011 have also be-come members As envisaged by the Treaty on the European Union, all EU Member States have to adopt the euro at some point Only the United Kingdom and Denmark have opted out of this requirement, as has Sweden for the time being The remaining Member States have not yet fulfilled the convergence criteria, which is why not all EU Member States are part of the eurozone, but rather “only” 17 The European Monetary Union project is therefore, at least technically, an ongoing process and far from being fully completed

The various attempts to realize monetary integration show that progress was erratic rather than steady Not least, this was caused by diverging views between the countries While on the one side “mon-

16 2 The Path to European Monetary Union

etarists”, mainly represented by France, supported greater exchange rate stability and exchange rate support mechanisms with the underly-ing assumption that convergence would be a result of monetary inte-gration, “economists”, mostly in Germany, on the other side stressed the importance of achieving convergence and political integration first as a precondition for an economic and monetary union (Issing

2008) Following this school of thought, the German government der Chancellor Kohl actually advocated the need for a closer political union, but that was rejected by the French president Mitterand This controversy is not only essential for understanding past struggles to move forward on monetary integration, but it is also relevant in to-day’s controversy surrounding the need for more fiscal and political union (see Sect 7.3)

Marsh D (2009) Blood, gold and the euro: the politics of the new global rency Yale University Press, Yale

M Heise, Emerging from the Euro Debt Crisis,

quent recession weighed heavily on public finances and made many countries, including Germany and France, breach the 3 % threshold of the Maastricht treaty The European Central Bank under Wim Duisen-berg reduced interest rates, as did all other major monetary authorities With slowly improving economies and very low interest rates, credit growth was re-ignited In the course of the first decade of this century the financial boom accelerated and created enormous leverage and dangerous macroeconomic imbalances in some of the euro-countries (see Chap 6.2) The fiscal situation improved on average in the boom years, but none of the countries actually achieved sizeable surpluses that would have stabilized activity in the economies and reduced the debt load in a meaningful way The stability pact had lost its teeth due

to interventions by Germany and France in 2003 With the crash of the economies in the Great Recession, the underlying debt problems immediately and very forcefully re-emerged

The low interest rates and the benign assessment of country risk during much of the last decade play a major role in explaining the crisis As the reduction of interest rates and the ensuing credit boom fuelled economic growth, investors on financial markets disregard-

ed many risks Countries like Greece, Portugal or Ireland, that were

Fig 3.1 Milestones of the euro crisis and sovereign bond spreads For EMU stage 1–3 see Chap 2 PSI public sector involvement LTRO longer-term refinancing operations OMT outright monetary transactions (Data Source:

already exhibiting major imbalances in 2005 and 2006, were priced

at rates close to German levels on government bond markets Strong growth in these economies led to myopic views on financial risks Fur-thermore, in the low interest rate environment, investors were search-ing for yield Small interest advantages of peripheral EMU countries were sufficient to create demand by banks and institutional investors While government bonds mostly remained in the balance sheets of the financial institutions, other spread products like the various US subprime mortgage structures were offloaded into special purpose ve-hicles (SPVs) lacking transparency and capital substance Credit was readily available and the leverage ratios of banks increased on a broad scale This should have been a clear warning sign, as credit bubbles

in a historical perspective typically precede financial crises arick and Taylor 2009) And it happened again The crisis set in in 2008/2009, when asset prices fell dramatically and the notion of nega-tive correlations between asset classes had to be thrown overboard Capital shortage and systemic risks in the financial sector developed Banks started unloading assets and cutting loan supply This of course exacerbated the public debt crises (Welfens 2012)

(Schul-The period of benign risk assessments concerning government bonds in the eurozone actually lasted until about the middle of 2010 From then on, risk premia started to rise, first slowly, then strongly

A historic walk by Angela Merkel and Nicolas Sarkozy along the beach of Deauville, France had its impact In these hours of October the 18th, a deal was struck between the two European leaders The German chancellor accepted the French “non” with respect to an au-tomatic penalty procedure for fiscal rule breakers in the Growth and Stability Pact and the French president backed off from his position to rule out the risks of an outright haircut for private investors in Greek bonds Germany had been advocating such an involvement of the pri-vate sector (PSI) as tax payers in Germany had become wary of bail-ing out Greece with big loans and thereby shielding banks and other investors from major losses The first attempt to involve the private sector was by asking banks and insurers for a roll-over of maturing Greek debt into new issues of Greek bonds The idea of the roll-over was to prevent a full blown default that could have led to fire sales and capital flight on a big scale But after many meetings organized

by the IIF (Institute for International Finance) and supported by BNP

3 The Evolution of the Debt Crisis

it became clear that any type of roll-over would also create major ance sheet impairments So it was finally accepted that there would

bal-be a haircut for private sector investors At first it was fixed at 21 %

on a net present value basis (calculated by discounting the low nal interest rates of new Greek bond issues with the much higher average rates that were priced in on government bond markets and that reflected a serious risk of default) It soon became evident that the 21 % PSI was far too low to yield a significant improvement in Greece’s debt dynamics In negotiations between the private sector and the public sector the size of the haircut was subsequently in-creased and finally reached around 75 % (on net present value basis) when the deal was finalized in January 2012 The public sector had a strong influence on this outcome, as it was providing some credit en-hancement in the form of EFSF bonds for the new Greek issues This came in the form of bonds issued by the European Financial Stability Facility (EFSF) that had been established in 2011 to prevent the crisis

nomi-in nomi-individual countries from spreadnomi-ing throughout the eurozone The overall haircut of the private sector amounted to EUR 107bn or 30 %

of the total outstanding Greek debt at the end of 2011

In the course of the negotiations on the Greek haircut, the risk mia for other countries on financial markets had been edging up For Ireland and Portugal they had reached more than 10 % by the middle

pre-of 2011 The fundamental concern expressed by the French president, which, by the way, was shared by the ECB and national central banks, proved right In times of uncertainty and “angst” on financial markets,

an explicit haircut on a formerly safe asset leads to even more risk aversion and a reduction of exposure with respect to other EMU coun-tries as well For this reason the PSI is often said to have been the big-gest mistake of all Judging by the coincident rise of the risk premia for other sovereign borrowers this assessment seems to be right But with the benefit of hindsight, one may counter that a default on Greek bonds would have been inevitable in any case as the Greek situation developed even worse than expected This we can leave for the his-tory books to figure out But what needs to be learned are lessons concerning the management of such processes of sovereign default They should be decided much more quickly, not in a drawn-out public debate, and they should not be restricted to the private sector while giving seniority to public entities

3 The Evolution of the Debt Crisis

The default of the Greek sovereign created a major break in the assessment of government bonds as an asset class Sovereign risk of the eurozone in general has been reclassified by investors from a risk-free asset to a credit with default potential The risk awareness of investors was accentuated by the perception that policymakers will try to impose a disproportionate share of any credit losses on private sector creditors This perception is based not only on the Greek PSI but also on public debates about the seniority of public sector claims

in the course of bailouts through the EFSF and later the ESM that was installed as a permanent rescue mechanism The classification

of sovereign debt as a risky asset becomes a systemic problem when potential losses exceed the risk-bearing capacity of the financial sys-tem In case of big sovereign debt markets like Italy or Spain this can easily become relevant Even a 50 % haircut on both these mar-kets would be larger than the excess capital of financial institutions (capital above and beyond regulatory minimum required) Deteriora-tion of sovereign debt quality therefore impairs the credit quality of banks and other financial institutions and thereby causes a negative feedback loop from the sovereign debt crisis to the banking and the financial system Financial institutions that are scrutinized because

of their holdings of government debt obviously try to reduce their exposure and thereby exacerbate the problems for the economy and for government finances

For an effective crisis management it is therefore crucial to sever this fatal link between banks and sovereigns, stopping the negative feedback loop Consequently, two decisions were taken in the sum-mer of 2012 that equip crisis managers with more powerful instru-ments to achieve that goal: The European Council decided to es-tablish a European Banking Union with a single supervisor, paving the way for using ESM-funds for direct bank re-capitalizations; and the ECB decided to purchase, under certain conditions, government bonds on an unlimited basis (OMT-programme), effectively cap-ping the rise of risk premia The ECB announced this exceptional policy measure as the increasing fragmentation of the euro financial market led to highly diverging credit conditions within the eurozone impairing the monetary transmission channels Together with the establishment of the ESM, these two decisions, however controver-sial, did a great deal to alleviate tensions and—for the time being—restored a sense of stability to the eurozone

3 The Evolution of the Debt Crisis

lever-3 The Evolution of the Debt Crisis

of monetary integration in itself is not easy to disentangle A health warning is therefore appropriate for the following paragraphs Pin-pointing benefits or downsides of the euro is a counter-factual exer-cise It is not known how the economies would have developed over the 13 years if national currencies had prevailed Economics cannot produce clinical tests where the actual development is compared with

an identical control group of countries that were not subjected to the treatment of a currency union (Bofinger 2012, p 152) From a con-ceptual point of view, the countries should have benefited from the following effects attributed to a currency union: an intensification of trade and investment through stable exchange rates, more price transparen-

cy and competition, lower transaction costs and an integration of financial markets leading to a major role of the euro in international trade and finance and to lower capital costs All these effects should eventually feed through into higher growth and employment

4.1 A Global Currency Emerges

So how does the euro score? In many respects, the performance of the euro can be divided into a positive period lasting until 2009 and

a negative one thereafter which erased many of the job and income advances in the years of growth One success however has been sus-tained over the whole period of the euro’s existence: the fact that the currency, a means of transaction for 330 million people, has been a stable currency in terms of low inflation and that it has maintained its second position behind the US dollar The share of euros in inter-national central bank portfolios is still estimated to be around 25 %, down only marginally on the pre-crisis peak (Fig 4.1) And, despite the crisis, the exchange rate of the euro vis-à-vis the US dollar is presently (Jan 2013) even higher than it was when the currency was launched in 1999 (Fig 4.2)

4 Economic Impact of the Euro—Who Benefits?

The aura of a fundamentally stable, large currency has prompted many neighbouring countries to link their currencies to the euro Switzerland, part of neither EMU nor the EU, uses the euro as refer-ence currency Six EU countries (Denmark, Latvia, Lithuania, Bul-garia, Czech Republic and Romania) have tied their currencies very

Fig 4.1 Currency composition of global foreign exchange reserves (Source: IMF Statistics Department COFER database and International Financial Statistics)

Euro area-17 countries nominal effective exchange rate vis-à-vis EER-20 group of trading partners (lhs)

EUR/USD spot rate (rhs)

4.1 A Global Currency Emerges

closely to the euro, partly via a currency board, along with a number

of other countries that are keen to join the EU in the coming years (for example Kosovo and Croatia) Apart from these European countries, there are also some African countries using a peg with the euro For these countries, the euro has replaced the French franc as anchor cur-rency Additionally some other countries use currency baskets involv-ing the euro, among them most importantly the Russian Federation, giving the euro a share of 45 % in their basket

4.2 Low Inflation in the Eurozone

The success of the euro in stabilizing prices can be seen clearly in a longer-run perspective Inflation was dangerously high in many of today’s euro countries in the early 1990s But rates of price increases converged towards the lower level of the stable countries even before the euro was introduced (Fig 4.3) Low inflation was, of course, one

of the preconditions for joining the euro More precisely, the vergence criterion for price stability required a candidate’s average inflation rate, observed over a period of 1 year before the examina-tion, to be at most 1.5 % points above the three most stable countries

con-Fig 4.3 Inflation rate convergence due to the euro Chart shows annual % change

in consumer prices (HICP) (Sources: EcoWin and Allianz calculations)

Inflation remained benign throughout the decade The recent slight uptick since 2011 is basically a result of rising commodity prices and administrative price increases through higher value added taxes

or service fees that governments are enforcing, especially in tries grappling with budgetary consolidation It is worth noting that improvements in inflation were not limited to the formerly high- inflation countries of the South Germany also experienced lower inflation after the euro was introduced than in the decade or de-cades before (Fig 4.4) Of course the disinflation seen over the last twenty years was also a global phenomenon attributable partly

coun-to the strong competition of rising emerging markets, but also in

an international comparison the performance of the euro has been quite positive

4.3 Impact on Growth Inconclusive

While the internal and external stability of the euro and its ness as an international currency seem relatively clear-cut, the impact

attractive-of the euro on growth within the union and for the individual member states is much more controversial (Fig 4.5 and Fig 4.6)

Fig 4.4 Inflation rates also lower in stable countries Average yearly rate before (1990–1998) and with the euro (1999–2012) (Sources: EcoWin and Allianz calculations)

1998 1999- 2012

1998

1998

1998

1990- 2012

2012

2012

4.3 Impact on Growth Inconclusive

4 Economic Impact of the Euro—Who Benefits?

Fig 4.5 Economic growth: High divergence Index with base year = 1999 (Sources: EcoWin, Allianz calculations)