European Integration: The Euro and the ECB

Transcription

1 European Integration: The Euro and the ECB A view from across the pond November 29 th, 2017

2 The Euro in Crazy Brief historical context: World War I: Treaty of Versailles: Crippling War Reparations (The Economic Consequences of the Peace, J.M. Keynes) World War II: (Europe, once again, devastated by War) Post-War Europe, 1950s onward, motivated by striking economic alliances to limit the risks of another war.

3 European economic integration: stepwise but unmistakable, Treaty of Rome, 1958 Maastricht Treat, 1993 Trade restrictions were reduced or eliminated. Impediments to travel were greatly reduced.

4 The Final Step? The United State of Europe 17 nations using one currency, under the control of one central bank France wanted a return to geo-political relevance, convinced Germany that: In unity there is strength Rest-of-Europe envied low borrowing costs that Germany had secured via its tough stance on inflation. Germany, paranoid about inflation, insisted ECB must operate on Bundesbank principles

5 The Problem? Germany has a long history of super competitiveness

6 Unit Labor Costs? Labor works to produce stuff, OUTPUT. How much stuff do they produce each hour? Productivity=Output per hour How much did an hour s worth of stuff cost? Labor Costs = Hourly Wage rate Changes in Unit labor costs roughly: (%Δ hourly wage rates) (%Δ output per hour)

7 Calculating German Unit labor costs: Labor productivity = output/hour Hourly wage rates = D-marks/hour unit labor costs = D marks hour output hour = D marks hour hour = D marks output output

8 Germany vs. Italy: A stylized depiction annual growth rate German Labor Productivity (output per hour) 2.0% German hourly wage rates (D-marks per hour) 2.0% German unit labor costs (D-marks per unit of output) annual growth rate Italian Labor Productivity (output per hour) 1.0% Italian hourly wage rates (Lira per hour) 3.5% Italian unit labor costs (Lira per unit of output)

9 Suppose Italy s Lira Is Stable versus Germany s D-Mark? Then Italy s labor costs jump versus Germany s German unit labor costs (D-marks per unit of output) Italian unit labor costs (Lira per unit of output) Italian Lira per D-mark 1 1 Italian unit labor costs (D-mark per unit of output)

10 How Economies are Connected (repeat slide from lecture 21) Goods & Services flow between nations: USA sends corn to China China sends flat screen TVs to the USA Financial Assets flow between nations China s central bank bought billions of U.S. treasuries U.S. Companies invest $billions building factories in China

11 GOODS FLOWS: Italy s labor costs rise faster than Germany s. If the lira and d-mark are stable, Fiat prices soar versus Volkswagen Prices. What will that do to the Italy/Germany Trade picture? annual growth rate Volkswagen Price 2.0% 1,000 1,150 Fiat Price 3.5% 1,000 1,410 Italian Trade Deficit (% of GDP) 1% 4%

12 Italians demand more German goods and buy D-marks. If the Italian Central Bank ignores these flows, the lira falls versus the d-mark. Look at our renminbi slide, below

13 . In this case it would be lira/d-mark. The price of the d-mark rises, versus the lira. Lira/d-mark

14 This is roughly what happened. Italy s Central Bank periodically devalued the Lira. Suppose in this example they do so by 28%, versus Germany s D-Mark? By driving the lira lower, the Bank of Italy drives Italian labor costs down versus Germany German unit labor costs (D-marks per unit of output) Italian unit labor costs (Lira per unit of output) Italian Lira per D-mark Italian unit labor costs (D-mark per unit of output)

15 Italian Lira per German D-Mark Italian workers remained competitive As the value of their wages fell, in D-mark terms

16 FINANCIAL FLOWS: Why were Italian interest rates, before the euro, much higher than Germany s? ULC differentials made Italian products uncompetitive. Italy s trade deficit would swell, its economy would struggle. The Central bank of Italy, periodically, would drive the lira sharply lower. This would drive the value of Italian bonds sharply lower, in the eyes of global investors

17 The Bank of Italy, as it rescued the Italian economy, explains, higher Italian interest rates Periodically, the Italian central bank would drive the Italian Lira sharply lower, versus the German D-mark Italian 10-year bond, price, (lira/bond) lira/$ Italian 10-year bond, price, ($/bond) 10 8 Anyone who owned Italian bonds would see their value plunge, in $ or D-mark terms. So Italy paid a premium interest rate, to compensate for the risk of a big plunge in the lira.

18 Uncovered Interest Parity (we will cover this on Friday)

19 Before the creation of the euro? The Piigs had much higher rates:

20 Before the creation of the Euro? Not perfect, but functional. A falling Italian Lira or Spanish peso, or Greek Drachma, CUT the global purchasing power of workers in those nations, and, for a time the workers would, once again be competitive with Germany. We said you can t cut workers nominal wage rates. YOU CAN VIA A CURRENCY DEVAUATION.

21 Germany, after the euro is created, becomes the China of Europe Germany, via euro, has a fixed exchange rate in Europe. (just like China s peg exchange rate versus the USA) German banks lend gobs of money to the PIIGS (Portugal, Italy, Ireland, Greece, Spain): (just like PBoC buying U.S. treasuries)

22 The Problem? Germany s superior competitiveness persists, but the PIIGs cannot devalue their currencies, to regain their competitiveness.

23 Before the crisis? Italy, and other southern European nations, accepted ballooning trade deficits, while enjoying the superlow interest rates. They got the low interest rates of Germany:

24 Then the euro is tested! The Great Recession plunges economies around the world into deep trouble. Unemployment soars, globally. Government deficits soar: Tax receipts plunge when fewer people pay taxes Spending jumps when more people collect unemployment benefits, Southern European economies now have very big recessions, very big trade deficits and very big budget deficits. AND THEIR WOKERS UNIT LABOR COSTS MAKE THEM VERY UNCOMPETITIVE GLOBALLY

25 Suddenly the euro is a straight jacket. Italy and others cannot devalue, to regain competitiveness. In addition, the ECB, fails to play a key role: Why do we call government bonds RISK FREE? Because a Nation s Central bank can print money to honor its commitment to pay interest on government debt. The ECB, under Jean Claude Trichet, refused to do so.

26 The Trichet led ECB declares it won t defend government debt. Italy and other Southern European nations watch their borrowing costs soar:

27 Why did Brits avoid this second crisis? A central bank that can print money

28 Draghi replaces Trichet, declares I ll do whatever it takes, and the European government borrowing crisis ends. (Italian 2-year government interest rate)

29 ECB, , makes a bad situation much worse Q4:2007 Q4:2009 Q4:2013 Q3:2016 USA 4.8% 9.9% 7.0% 4.9% germany 8.5% 8.1% 6.8% 6.1% italy 6.6% 8.4% 12.5% 11.6% spain 8.6% 18.7% 25.7% 18.9%

30 But the underlying problem remains. German unit labor costs are 20% below southern European country prices What is the ECB mandate? 2% inflation How do you deliver 2% for Europe in a world where prices, Germany vs the south, come together?

31 We need inflation above 2% in Germany and below 2% in the south 5 years of 0% inflation in Italy and Spain 5 years of 4% inflation in Germany After 5 years, prices now are equal, and you did it, while still following the ECB mandate.

32 It is arithmetic. To meet both goals Germany needed to accept higher inflation Germany Italy Germany Italy

33 BUT GERMANY Refuses to embrace a period of higher than 2% INFLATION! Primus Inter Pares: IF THE ECB FEARS GERMANY AND GIVES THEM 2% INFLATION TWO OTHER THINGS MUST BE TRUE: REST OF EUROPE MUST SUFFER DEFLATION, IF THEY WANT TO GET LABOR COSTS EQUAL OVERALL INFLATION IN EUROPE WILL BE BELOW TARGET

34 Output Growth will be weak inflation will remain well below target WE KNOW THAT WAGES ARE VERY HARD TO GET BELOW ZERO THAT MEANS ITALY AND SPAIN AND OTHER WEAK SISTERS FACE EXTENDED WEAK PERIODS. IT ALSO MEANS BELOW TARGET EUROPEAN INFLATION

35 EURO AREA INFLATION: Below 2% target

36 Imagine using a dual mandate: Spain vs Germany? Germany, the Taylor Rule: short rates = 1% +0.5*(1-2) + (6-5) + 2 = 3.5% Spain, the Taylor Rule: short rates = 1% +0.5*(1-2) + (8-17) + 2 = -5.5%

37 OPTIMAL CURRENCY AREA? I GO WHERE THE JOBS ARE!