Presentation of André Sapir, Professor of Economics, Université Libre de Bruxelles Senior Fellow, Bruegel

1. The Euro Area Crisis and Reforms
Fiscal Discipline and Growth
André Sapir
Professor of Economics, Université Libre de Bruxelles
Senior Fellow, Bruegel

2. 2
Two views about what went wrong and how to fix it
 Diagnosis. The system was fundamentally flawed: a monetary
union needs a political union
 Remedy: “more Europe”
 Diagnosis: The system was not fundamentally flawed: a monetary
union among sovereign states can work, provided each state
respects the rules
 Remedy: “better Europe”

3. 3
The original incompatible trio
 You cannot have a situation with
» Fixed exchange rates
» Financial integration
» Monetary autonomy
 Financial integration was central in the arguments in favor of
monetary union, yet its consequences for financial stability was
largely ignored. No integration of financial policies.
 The focus of Maastricht was on price stability. The ECB is a rare
case of a CB NOT established in response to a banking crisis
» The primary objective of the ESCB is to maintain price stability
» The ESCB shall contribute to the stability of the financial system

4. 4
Lesson from the crisis: the new incompatible trio
 You cannot have a monetary union with
» Financial stability
» Financial integration
» Inappropriate common fiscal and banking policies and institutions
 Especially with important economic differences between countries

5. 5
An important benchmark: The Swedish ‘90s crisis
 Around the same time as Maastricht, Sweden suffered a major
financial and then banking crisis
 The Swedish response to the crisis is generally regarded as a
model for other countries
 The components of the Swedish strategy:
» Comprehensive and rapid banking resolution
» Supportive macroeconomic policies
 Fiscal expansion => Next pages
 Monetary expansion, including currency depreciation
» Structural reforms
 Fiscal reform
 Product market liberalization
 Labor market and social reforms

6. 6
Deficit-to-GDP ratio, 1985-2005
-3
Source: Jonung (2009)

7. 100
120
140
20
40
60
80
0
1985
1986
1987
1988
1989
1990
Data source: AMECO February 2013
1991
1990: 41%
1992
1993
1994
1995
1996
1997
1996: 74%
1998
1999
2000
2001
2002
2000: 54%
2003
2004
2005
2006
2007
2008
2009
2010
2011
Debt-to-GDP ratio, 1985-2013
2012
2013
SE
7

8. 100
120
140
20
40
60
80
0
1985
1986
1987
1988
1989
1990
Data source: AMECO February 2013
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Debt-to-GDP ratio, 1985-2013
2012
2013
SE
EA12
8

9. 100
120
140
20
40
60
80
0
1985
1986
1987
1988
1989
1990
1991
Data source: AMECO February 2013
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Debt-to-GDP ratio, 1985-2013
2012
2013
IT
SE
EA12
9

10. 10
The system failed
 Prior to the crisis, surveillance was inadequate
» It did not understand well the nature of the risks, including for BOP
» Fiscal surveillance: SGP focus on deficit rather than debt
» No EZ financial surveillance, inadequate national surveillance
 Prior to the crisis, adjustment mechanisms were inadequate
» The REER channel did not work well: divergences in competitiveness were not
corrected automatically or otherwise
 When the crisis occurred, the system lacked adequate tools to
deal with it

11. 11
The system allowed huge imbalances
 Very large current deficits
 Huge build up of private and public debts, and external debts
 Loss of competitiveness
 The music stopped when the financial crisis started

12. 12
Effect of EMU on external imbalances: Current account
6
4
2
0
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
DM
GIIPS
-2
-4
-6
-8
Correlation (GIIPS,DM) Correlation (GIIPS,DM)
1960-1998: +0.28 1999-2012: -0.73
Data source: AMECO May 2012

13. 13
Same for Germany and Greece
10
5
0
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
D
-5
GR
-10
-15
-20
Averages 1960-1998 Averages 1999-2012
D = 0.9 D = 3.7
Data source: AMECO May 2012
GR = -0.9 GR = -12.1

14. 14
Debt-to-GDP ratio, 1985-2013

15. 15
Debt-to-GDP ratio, 1985-2013

16. 16
Risk of sudden stop not understood before Lehmann
100
GREECE
IRELAND
80
ITALY
SPAIN
PORTUGAL
60
BELGIUM AUSTRIA
UNITED KINGDOM
40
DENMARK NETHERLANDS
FRANCE NETHERLANDS
SWEDEN
SPAIN
FINLAND
UNITED KINGDOM FINLAND GERMANY
20
GREECE ITALY
SPAIN
PORTUGAL
GREECE IRELAND SWEDEN
IRELAND FRANCE BELGIUM
DENMARK
UNITED ITALY
KINGDOM AUSTRIA NETHERLANDS
DENMARK GERMANY
PORTUGAL
FINLAND SWEDEN
FRANCE AUSTRIA GERMANY
BELGIUM
0
-15 -10 -5 0 5 10
Current Account over GDP
31/12/2006 29/12/2007 20/10/2008

17. 17
Debt-to-GDP ratio, 1985-2013

18. 18
Cumulative capital inflows in €A countries, 2002-12
Greece Portugal
Spain Italy

19. 19
Sovereign debt crises possible (likely?) in € area
 € area governments issue debt in a foreign currency, just like in
emerging countries!
 What EA mechanism could have prevented such crisis?
» Debt mutualization: replace national treasury by € area treasury
» If no debt mutualization: strict rules to contain sovereign debts,
including rules on private debts
 What EA mechanism could have lessened the effects the crisis?
» If government solvent
 ECB to act as LOLR
 ESM lending
» If government not solvent
 European Sovereign Debt Resolution Mechanism
 Debt redemption mechanism

20. 20
The response: A Swedish strategy was not feasible
 Comprehensive and rapid banking resolution: Impossible, no FDIC.
 Supportive macroeconomic policies
 Fiscal expansion: Impossible because debt levels were already high and
danger of sovereign debt crisis => fiscal austerity, but self-defeating
 Monetary expansion, including currency depreciation: Impossible
 Structural reforms: difficult w/t supportive macro policies
 Fiscal reform
 Product market liberalization
 Labor market and social reforms
 => Limits of a “currency without a state” in a crisis situation

21. 21
What then was the € area strategy?
 Central role of the ECB, but limitations due to absence of a euro
sovereign (TPS again: “the loneliness of the ECB”)
 Banking: each country responsible for his own situation. Future:
creation of a banking union, but w/t FDIC?
 Supportive macroeconomic policies: Not much
 Fiscal expansion: austerity in deficit countries albeit with EU-IMF
assistance; but no expansion in surplus countries
 Monetary expansion: slow internal devaluation, but external value of
the euro remains high
 Structural reforms: difficult w/t supportive macro policies
 Fiscal reform
 Product market liberalization
 Labor market and social reforms
 => No real strategy, besides “putting one’s house in order” with some assistance

22. 22
Growing surplus/deficit country divide
Unemployment

23. 23
Deficit countries have two problems
 Obsolete socio-economic model already prior to joining the
euro due to
» Increased global competition from emerging countries
» Increased competition within Europe from the NMS.
 Model managed to survive thanks to euro adoption of the euro
which permitted large net external debt positions, whereas the
euro should have been an impetus for reform.
 Now these countries have two problems
» A competitiveness problem, not only intra-€A but also towards the NMS
» An external debt problem

24. 24
Twin problems of competitiveness and debt
 Correcting the competitiveness problem requires lower prices
in the periphery than in the core
 But too low prices risk increasing the debt burden in the
periphery by lowering nominal GDP
 In addition austerity measures aimed at lowering public debt
also lower nominal GDP
 Hence correcting competitiveness and public debt risk creating
self-defeating debt deflation in the peripheral countries

25. 25
Austerity alone is not working
 Are fiscal contractions expansionary? No, unless accompanied by
other policies
 Do fiscal contractions reduce deficits? Yes, but by less than 1
Note: a positive
sign indicates a
reduction in the
deficit.
Source: Martin Wolf, FT 1/5/12

26. 26
Growing surplus/deficit country divide

27. 27
The incompatible trio: Reforms
1. Reduction of economic differences between MS in some areas:
reforms of national policies (e.g. labor markets) and EU policies
(e.g. Structural Funds)
2. Creation of common policies and institutions in some areas: a
banking and (?) fiscal union

28. 28
Two big question marks
 It’s relatively easy to design the LT solution, involving economic
convergence and the build up of a banking and fiscal union based
on a strong political commitment (“A genuine EMU”)
 But two big questions about how to get from here to there
» Are the existing economic, social and political differences between EZ MS
really compatible with a commitment in favor of banking and fiscal union?
» Is there sufficient political commitment not just for the LT vision but also
about how to deal with the twin legacy problems of
 Competitiveness and asymmetric adjustment
 (External) debt
leading to potentially unsustainable debt and social situations in the periphery?