Closed-Door Workshop Eurozone in the Doldrums. The Legacy of the Eurocrisis ISPI-Milan, 13 March p.m.

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1 Closed-Door Workshop Eurozone in the Doldrums. The Legacy of the Eurocrisis ISPI-Milan, 13 March p.m. Paul DE GRAUWE, London School of Economics If we look at the cumulated current accounts of Eurozone countries, we see imbalances in the euro area between 1999 and 2013 have increased instead of shrinking. The Eurozone, which was built on the promise of progressive integration and harmonization of countries sharing the same currency, has instead gradually split into creditor and debtor nations. On the one hand, austerity has worsened this problem: unable to adjust by devaluing their currency, debtor countries were left with internal devaluation, and this meant higher unemployment and wage shrinking. This, in turn, generated stagnation in the debtor countries and, from there, in the Eurozone as a whole: the Eurozone has recovered since the crisis, but its overall GDP in 2014 was still lower than in On the other hand, austerity meant that the rebalancing imposed on euro area countries was asymmetric: debtor nations had to adopt fiscal tightening, while creditor countries could continue in their business as usual model. This asymmetric adjustment mechanism, which was in-built into austerity measures and rested on the Stability and Growth Pact, supported a deflationary bias in the Eurozone. This is because, by expecting low economic growth, economic operators also expected low inflation and interest rates. Moreover, austerity forced debtor countries to increase their savings (the Eurozone reached an overall current account surplus position after the crisis), and the low level of consumption again pushed inflation downwards. If not appropriately tackled, low inflation risks becoming a permanent feature of the Eurozone economic landscape. The most striking feature of the legacy of the Eurocrisis is that, despite intense austerity programmes that have been triggered since 2010, there is no evidence that such programmes managed to increase the capacity of debtor countries to continue to service their own debt. On the contrary, deflation or persistently low inflation make it harder to reduce debt burdens, because the nominal debt level remains very near the real debt level or even increases. At the same time, austerity-induced stagnation in economic growth cannot act through the denominator of the debt/gdp level. My contention is that a more symmetric fiscal adjustment, in which creditor nations properly stimulate their economies, would have reduced the price periphery countries have to pay to achieve a given

2 improvement in their government budget balances. Austerity has worsened the prospects of periphery countries also because it subjected them to a composition fallacy, namely that what works for one country will continue to work when many other countries apply the same policies. The problem is that, when all countries are forced to deleverage through austerity (i.e., attempting to create current account surpluses), each country s attempt to do so makes it harder for the others to achieve their objectives, forcing them to increase their austerity effort. In the end, they will not be as successful as they would have been acting alone while, due to austerity, GDP will be lower everywhere. Moreover, austerity programmes have undermined the legitimacy of national governments that agreed to enter the Eurozone with the mandate to provide some protection against the booms and busts of capitalism. Eventually, the political systems of periphery countries will crack under the austerity burden we are currently seeing this in Greece and Cyprus. Will Portugal follow suit? What about the striking ascent of Podemos in Spain, at least looking at opinion polls? What will happen when bigger Eurozone countries will all line up against austerity measures and, namely, against net creditor countries? These challenges are incredibly daunting. But there are options for the future. First, we need to solve the legacy of the Eurocrisis. Secondly, we need to correct for design failures of the Eurozone. In the first respect, the legacy of the crisis in the euro area has led to unsustainable debt levels in some debtor countries. In my opinion, debt default and restructuring will be inevitable: the only question, then, is when to do it. A rational solution dictates that creditor nations accept a loss as soon as possible, in order to recover as much credit as possible from a defaulting debtor. The later they agree to do this, the less money they will recover from near-default countries such as Greece. As for correcting Eurozone s design failures, we should all acknowledge that capitalism is a great system, probably the best we can have for allocating resources between different economic purposes, but its boom-and-bust dynamics are endemic. The problem is that Eurozone countries business cycles did not align upon adopting the common currency. Moreover, banks and sovereigns have continued their deadly embrace, as member states banks did not diversify their portfolio by buying up government debt from many Eurozone countries, but mainly sticked to buying domestic sovereign debt. At the same time, fiscal and exchange rate stabilizers that existed at the national level (in times of crisis, a country could either support spending through debt or devalue its currency) have been stripped from Eurozone countries without being transposed at the monetary union level. This left the member states naked and fragile, unable to deal with coming disturbances. In light of all this, how can we redesign the Eurozone? I see no other alternative than to strongly increase coordination of macroeconomic policy between EMU countries. Ultimately, such coordination should bring about the completion of the banking union (of which we see the first steps today) and the start of a real fiscal union. A real fiscal union, in turn, requires a real political union, following the principle of no taxation without representation. In the short term, what we need is monetary and fiscal expansion at the EU level. The ECB has started its quantitative easing programme, and that is for the better. However, we still need fiscal policy to be managed, or at least coordinated, at the EU level. In the meantime, fiscal policy should focus on spurring investment, which has been one of the major victims of ill-advised macroeconomic adjustment in the Eurozone. As austerity programmes led to strong declines in public investment (from almost 3% of GDP in 2007 to just 2% today), this leads to lower aggregate demand today, and lower potential growth in the future. Public investments should be boosted everywhere, but even more so in Germany a country that, today, can borrow almost for free. To conclude, in the long-run, the resilience of the Eurozone depends on the continuing process of political unification, which must proceed hand in hand with the creation of a fiscal union. Such a political unification is needed because the Eurozone has dramatically weakened the power and legitimacy of member states governments, and left a vacuum in their place instead of creating a supranational government.

3 Jakob DE HAAN, Professor, University of Groningen In my view, to improve the sustainability of Member States fiscal policies is of paramount importance, because unsustainable fiscal policies will tend to generate problems for countries in a currency union. This, in turn, will force other countries to intervene to save them (even though in the Stability and Growth Pact we agreed to the no bailout clause, we knew this would not have been credible right from the start). At the same time, a country on a fiscally unsustainable path would generate problems even for the ECB, by creating asymmetries and imbalances in the Eurosystem, thus forcing the ECB to intervene. It is true that, in a common currency area, no currency devaluation is possible for a single country. However, there are other ways for a country to adjust, and I think the most important problem facing the Eurozone today is that there are no mechanisms in place to ensure this is what happens if a country embarks on a fiscally unsustainable fiscal policy path. Moreover, Prof. De Grauwe said that quantitative easing from the ECB was welcome, but was also too little, too late. I am not too sure about that: I think the timing, at least, was quite accurate. Even so, although I think it is good that the ECB took this step, I am not so sure that it will be successful. It will certainly manage to affect the exchange rate, pushing down the value of the euro with respect to other currencies, and thus raising Eurozone s overall competitiveness. But will this help to close intra- Eurozone imbalances? I am not so sure about that, and NiGEM modelling tells us this may not be the case. In fact, quantitative easing may even raise risks by reducing the probability that a structural adjustment continues or gets under way. This is because QE pushes down sovereign bond yields, thus lowering risk spreads. This, in turns, reduces market pressure to follow in the path of structural reforms which we know to be politically costly and to need a considerable time lag before their effects can come to fruition. Finally, on public investment, I think there is a gross misunderstanding of the whole concept. Many people feel that public investment is a good thing in itself. In fact, some of it is just a waste of money. Indeed, the higher the potential effect of a certain type of public investment, the less it tends to be politically feasible. This is because the best public investment is often invisible, and comes in the form of higher research and development expenditure, or maintenance for already-existing infrastructure. Meanwhile, public investment usually gets wasted on new projects, such as new roads, interconnections, etc., while neglecting much-needed, but also much less popular, maintenance and improvements on existing infrastructure. Mark JENSEN, Federal Reserve Bank of Atlanta I think Prof. De Grauwe touched upon many important points. Athe same time, I do not think that the ECB needs better political accountability. Contrast the ECB response to how the Fed responded to the crisis. In 2007, nominal interest rates in the US were at 5%. The Fed started cutting interest rates in all the way down to 0%, but that didn t fix the liquidity problem, and actually highlighted a solvency problem in the country. Therefore, we turned to lender of last resort facilities. All these special facilities were Section 13 authorized, and were applied by Fed officials under extraordinary circumstance. This required no involvement from an elected official at all! This is where I disagree with Prof. De Grauwe: the ECB s delayed actions do not arise from a problem of democratic legitimacy. On the contrary, I believe that if Fed officials had to go to Congress to obtain approval, the proper monetary actions would have never been implemented in time. This actually

4 happened with quantitative easing measures different from lender of last resort facilities. Since they need to be approved by the Secretary of Treasure, QE decisions have become much more politicized. Given that there is no great difference between US and Eurozone in terms of monetary policy governance, I believe that this divergence in actions between the Fed and the ECB can actually be explained by effective political pressure that delayed actions in the Eurozone. The ECB does not lack political accountability: in fact, what it lacks is proper independence from political pressure. Fabian ZULEEG, European Policy Centre I do not see the issue of independence and accountability of the central bank as being the paramount problem in the Eurozone these days. The ECB did act at the end: you can argue whether it was too slow, or whether the QE is too small to make a difference. However, this points to the real problem of the Eurozone: the fact that it still is not a single government, but 19, and that they have different interpretations of what should be done about the crisis. So, the problem is political disagreement between governments at the member state level, and the fact that, as of today, there does not exist a mechanism to achieve political compromise between Eurozone governments that does not proceed through diplomatic, nation-state means. I think such a mechanism should be institutionalized, and this could only be achieved through a proper political union. But leaving utopia aside, what more can we do now? I think we should pay more attention to the Juncker investment plan. It is not a bad thing, it can be helpful, and it is actually a first step in the right direction. Moreover, I feel that our discussion has been focusing too much on debt and deficit levels, while we should recognize that there are structural problems, which amount to productivity growth problems. How do we move forward? A political and fiscal union is not feasible in the short-to-medium run: it is impossible to change the Treaties, given that there is a clear lack of trust between Member States, and between Member States and EU institutions; and citizens in most if not all Eurozone countries do not want more Europe, and may actually push for less. Moreover, we have to take into account German peculiarities, and the fact that this country alone can drive EU integration, but it can also veto it. What, then, can we do? I think the only solution is to take incremental steps. We will have to find support from some kind of conditionality: I will aid you if you undertake structural reforms. We should also push for the creation of a small instrument with fiscal capacity, and then find the political support to slowly ramp it up, working towards future fiscal stabilizers. Finally, we could include a golden rule of some kind that accounts for the recognition that investment is better for public finances than simply supporting current expenditure. We should also build trust between governments. We should create new independent bodies, because the current bodies are not trusted anymore. And, ultimately, we should convince Germans that if they agree to do something they are doing it because it is in their own national interest, not just the others. We must simply recognize, however, that it will take decades to get there and that, meanwhile, we are in for a bumpy ride. Giulia IORI, City University London I would like to focus on another issue which I feel has been neglected today that is, macro-prudential policies. There is a need to coordinate them much better than they are these days. Meanwhile, there has been a lot of work done in identifying macro-prudential instruments that can work properly. Today we can rely on measures of counter-cyclical capital buffers, leverage rations, etc., but

5 the financial system is much more complex and consists of several different institutions, so it is very important to build a good and encompassing governance system that can regulate what at first seems to escape regulation. At the same time, it is very important that we study and understand the diverse business models and risk profiles of these institutions. And it is important that we assess possible transmission mechanisms that might spread a crisis. Just as an example, non-traditional lenders can introduce new sources of risk. However, even within the traditional banking system, how do you identify systemically important financial institutions? What we know today is that there are no really sound methods to identify them. Therefore, we should improve our models even before going out in search of shadow banking or other non-traditional lenders, given that it is even more difficult to identify systemically important non-banks. Until recently, the aim of macro-prudential regulation has been to simplify the complexity of the financial system, not to capture the whole system in its full complexity. However, it is not so obvious that trying to simplify is really going to give us a good measure to assess systemic risk, and it is certainly not going to eliminate it only hide it from view. It has frequently been proposed to concentrate banks and financial institutions into fewer, bigger entities. This has especially been a topic of contention when it comes to dealing with institutions that risk to face liquidity or insolvency crises. But is this a proper way to deal with risk, or are we just shifting it towards different subjects? And what kind of new vulnerabilities may arise from concentrations? We do not know this yet, and there is an urgent need to study these phenomena. To conclude, the macro-prudential approach must better capture the complexity of interactions between financial institutions, and between banks and non-banks. It must study non-linear feedback mechanisms, and be aware that risks are continuously evolving. Behavioral economics, agent-based modelling, and laboratory experiments can aid us in this. And this is what the RAstaNEWS project is all about.