- 1 Departures from optimum currency area criteria
- 2 The debt trap
- 3 Policy options
- 4 Policy constraints
- 5 References
Departures from optimum currency area criteria
Currency area theory is concerned with extent to which efficiency gains from currency area membership are offset by losses due to increased vulnerability to external economic shocks, and the term "optimum currency area" (OCA) denotes an area in which such offsets are absent. Although an idealistic concept, it has practical implications because the increased costs of recessions, brought about by increased vulnerability to shocks, can be large compared with the benefits of the efficiency gains. For that reason it is generally accepted that a currency area may not succeed unless it goes a substantial way toward meeting OCA criteria. A currency area fully meets OCA criteria if there is complete price flexibility, or complete cross-boarder mobility of labour and capital. An alternative requirement arises from the fact that increased vulnerability to shocks need not occur if every shock has the same impact on all the economies of the member states. The term "convergence" is sometimes used to denote a condition in which the economies of members states are so similar as to eliminate asymmetric shocks - or to denote an approach to that condition.
The eurozone has not satisfied the OCA labour migration or price flexibility conditions. Labour mobility is low and there is only limited wage and price flexibility. Nor has it satisfied the convergence condition. There has been less price convergence among eurozone countries than among European Union countries as a whole,, and there have been large divergences of productivity, unit labour costs, and current account balances. The progress toward convergence as a result of membership, that was expected by the early proponents of monetary union, has not occurred.
Academic contributions to the debate about the eurozone as a currency area have been summarised by Kenneth Rogoff
The debt trap
If the annual interest payable on a government's debt were to continue to rise faster than the national income, it would eventually exceed the feasible revenue from taxation. The process is normally hastened by the fact that government debt is traded in a well-informed market. Operators in that market would be aware of the approach of the point at which the government would be forced to default on its debt, and they would be increasingly reluctant to allow that government to continue to roll over its debt. The government concerned could seek to overcome that reluctance by offering them higher interest on future loans, but an increase in the interest to be paid would hasten the process and increase the reluctance of further potential investors. That is what is known as the debt trap, the price formulation of which is the debt trap identity.
The debt trap could be escaped:
- - (i) by repudiation of the debt;
- - (ii) (temporarily) by a negotiation with creditors to ease the terms of repayment (termed restructuring);
- - (iii) (temporarily) by getting the country's central bank to purchase the debt; or,
- - (iv) by a programme of reductions in public expenditure and/or increases in rates of taxation.
Options (i) and (ii) have the drawback of making future investors reluctant to buy the government's bonds. Option (iii) can also have that effect if it causes an inflation that reduces the value of the currency in which the debt is to be repaid. Option (iv) is free from that drawback, but is effective only if it avoids creating a recession that increases the deficit (by the operation of the country's automatic stabilisers).
Fewer options are available to members of a currency union, however. Option (iii) may be excluded by the fact that monetary policy is no longer under the control of the borrowing government. That fact also prevents the use of monetary policy to counter the recessionary consequences of (iv), (without which that option may be ineffective); and the rules of the currency union prevent the exchange rate deprecation that might otherwise counter them. To make (iii) possible and (iv) easier, a further option would be (v) - to leave the currency union.
The EU/IMF loans had been primarily intended to restore the confidence of the bond markets in their recipients' ability to meet their financial obligations and give the recipient governments time in which to restore their fiscal sustainability, and have been conditional upon the adoption of stringent fiscal adjustments. Since May 2010, the EU components of such loans have been supplied by the European Financial Stability Facility subject to the approval of the parliaments of the eurozone countries. Proposals to refinance the Facility by using the European Central Bank have not been adopted and, as it stands, it is too small for rescues of the larger eurozone countries such as Spain and Italy.
As one means of "leveraging" the European Financial Stability Facility, it has been proposed that it should offer partial guarantees against loss by a purchaser of a member government's bonds.(Reported to be under consideration October 2012)
Another form of leverage is the creation of a co-investment fund to enable the deployment of a combination of European Financial Stability Facility and private sector resources.
Before May 2010, the European Central Bank had used bond purchases only for the purpose of monetary policy, but in May 2010, in a major policy change, it decided to buy European government bonds in order to assist governments who were experiencing funding difficulties - a policy change that was opposed by Axel Weber, the then President of the German central bank. Purchases are reported to have included the bonds of all of the PIIGS countries, including Spain and Italy.
The purchase by its issuer of a bond that is trading below its par value relieves the issuer from redeeming it at par value when it matures.
In December 2010, two Eurogroup finance ministers put forward a proposal under which bonds issued by individual governments would be collectively guaranteed by the other eurozone governments, . Among variants on the concept are the "Blue Bond" proposal, under which eurozone governments would pool up to 60 percent of GDP of their government debt in the form of a common European government bond , and its "partial sovereign bond insurance" alternative . The German Council of Economic Advisors have suggested the joint issuance of bonds, which would be limited in time and size to bring public debt in all member states to below 60% of their GDP. A number of variants have been put forward A European Commission Green Paper identified three categories of what the termed "stability bonds":
- (a )the full substitution by stability bond issuance of national issuance, with joint and several guarantees:
- (b) the partial substitution by stability bond issuance of national issuance, with joint and several guarantees: or,
- (c) the partial substitution by stability bond issuance of national issuance, with several but not joint guarantees.
It has been argued by the economist Wolfgang Münchau, and others, that the eurozone embodies a logical inconsistency that will continue to make it vulnerable to economic shocks unless it is resolved by the introduction of some form of fiscal union. There have been a number of proposals that would serve the purpose without the imposition of a common budget. The decision of 9th December proposed that eurozone countries should be required to present their draft budgets to the European Commission, and that they should be submitted to the European Court of Justice for validation of their compliance with federal law - so that an invalidated national budget would be illegal.
It is generally accepted that the costs of sovereign default to all concerned are such as to make its avoidance a high priority objective. But it has been argued that, when default becomes unavoidable, some of those costs can be avoided by a timely "restructuring" agreement with the country's creditors. In May 2011, European Finance Ministers discussed the possibility of a rescheduling of the Greek government's debt (also referred to as "soft restructuring" or "reprofiling")', and a reduction by half of Greece's debt, was subsequently adopted as one of the decisions of October 2011.
European banks had already suffered reductions in their assets as a result of falls in the value of their holdings of Greek bonds, and a resulting reductions in their capital adequacy ratios had resulted in their failure to pass stress tests . Further large-scale recapitalisation, was considered in October 2011 to be a necessary adjunct to the restructuring of the Greek government's debts without which it would result in multiple bank failures.
The ECB as lender of last resort
It has been proposed that, instead of the provision of loans at the case-by-case discretion of member countries, the duty should be placed upon the European Central Bank to provide assistance to member governments when it is needed, raising the necessary funds by monetisation. That proposal has been rejected on the grounds of fear of moral hazard and of the possible creation of inflation as a result of the consequent increase in the money supply. Low interest European Central Bank loans to eurozone banks have, however, enabled those banks to increase the fiscal sustainability of member governments by buying their bonds.
In June 2012, European Commission President Jose Manuel Barroso called for the creation of a banking union and the Commission published an explanatory paper which outlined its possible features as including EU-wide bank capitalisation rules, a single EU banking supervisor to enforce rules and oversee risk controls,common rules for preventing bank failures and for intervening when a bank gets in financial trouble, and a single deposit guarantee scheme. In September the Commission published formal proposals . A further development would be to allow distressed banks to draw directly upon the European resources instead calling upon government resources
Since it is not open to eurozone governments to increase the international competitiveness of their countries' products by devaluation, some have sought to do so by measures to reduce the costs of production, for example by reducing the tax wedge that raises the cost of labour to employers above the take-home pay of employees. The same objective may be served by the downward pressure on wage rates brought about by increases in unemployment resulting from fiscal adjustments designed to restore sustainability.
Exit from the eurozone
Departure from the eurozone would enable a country to monetise its debt, and would offer the prospect of an increase in competitiveness resulting from a currency devaluation. However, according to a study by UBS economists, the benefits to a country like Greece would be overwhelmingly outweighed by costs. It would also result in mass sovereign and corporate default, a major increase in the cost of capital, and the collapse of its banking system  (the first-year cost of its departure was later estimated to be 40 to 50 per cent of GDP. ). The economic commentator, Anotole Kaletsky, has argued that the "seemingly impossible" solution of a German exit might become inevitable, and would be much less disruptive than a Greek expulsion because it would not trigger bank runs in countries, but would enable a devalued euro to be managed on less austere principles. But the UBS economists estimate that departure of Germany would lead to a first-year loss to its economy of 20 to 25 per cent of GDP.
The principal alternatives that have been put forward to the current policy responses to the crisis have been (a) the extension of the European Central Bank's limited practice of government bond purchases to the point of giving it the obligation to serve as member governments' lender of last resort, and (b) the issue by individual member government of eurobonds that would be jointly guaranteed by member states as a whole. The reason that has been put forward for their rejection by the eurozone's decision makers has been the fear that the moral hazard that is associated with financial rescues, would lead to reckless conduct by member governments, of the sort that would increase the prospects of a recurrence of the crisis. To counter that fear, it has been proposed that member governments should be required to submit budget proposals to the European Commission for approval, but there are doubts whether national parliaments would assent to such a surrender of sovereignty.
The European Central Bank
The European Central Bank would be able to make a decisive response to the crisis were it not for the constraint of its mandate, and were it not for the restrictive interpretation that it applies to its function. Article 123 of the Treaty on European Union prohibits it from buying bonds directly from member governments, so that an amendment to the treaty would, in principle, be necessary to enable it to act as their "lender of last resort" (there have been some small-scale purchases on the secondary market, however).
Treaty limitations apart, the Bank appears unlikely to adopt such a rôle. The economist Bradford DeLong has observed that, in a "radical departure from the central-banking tradition", the European Central Bank does not consider financial stability to be part of its core business . Statements by its governors confirm that they consider its function to be the avoidance of inflation, and that they would be very reluctant to use its powers for other purposes. Some of the Bank's governors have even opposed the minor interventions that have been made.
On December 1, the Bank's new President Mario Draghi said that more aggressive action would be taken to assist banks and governments if governments were to adopt a new "fiscal compact.", but on 8th December he rejected the idea, claiming that he had been misunderstood.
The European Commission
The Commission has put forward its proposals for the introduction of eurobonds and for improved fiscal integration but, although the European Union's treaties authorise the Commission to take the initiative in proposing legislation, legislative decisions (except those concerning competition policy) can be taken only by the Council of Ministers and the European Parliament.
|"This is not a euro crisis, it is a debt crisis in some euro states,"|
With the largest of the eurozone's economies, and as the largest contributor to its rescue measures, Germany's attitudes have necessarily had a decisive influence on the eurozone's response to the crisis. Before January 2012, the European press was virtually unanimous in the belief that its Chancellor, Angela Merkel dictates her conditions on what should be done., but reports of an alliance between Italy's Mario Monti and France's Nicholas Sarkozy suggest that Germany's dominance may have been successfully challenged.
The German Government has been opposed to any increase to the size of the EFSF "firewall", despite advice from the IMF and others that it is not large enough to deal with impending threats. It is also opposed to "any participation of the European Central Bank in the strategies to resolve the euro debt and banking crisis". It is also opposed to the European Commission's eurobond proposal. Chancellor Merkel described the proposal as "extremely regrettable and inappropriate", arguing that the case for it should be put at the end of the process of European integration, "if indeed it is put at all". Newspaper reports in Germany indicated that some within her Christian Democratic Union Party and the Christian Social Union might be willing to relax their objections to intervention by the European Central Bank if it were made conditional on the introduction of an effective system of fiscal integration . It became apparent, however, that their attitude was not shared by the leadership, which continued to reject all forms of short-term action, and to concentrate solely upon the terms of an eventual fiscal union.
According to a YouGov poll held in August 2011, most Germans disapprove of their government's handling of the crisis (75%), and they want no more bailouts (59%), but want Greece expelled from the eurozone (58%). But German opinion is divided on the question whether Germany should leave the eurozone (44% for/48% against) . In a further YouGov poll , the majority of respondents approved the decisions of 9th December, but did not expect them to help the crisis, and there was a small balance of confidence in Chancellor Merkel (56 against 40).
|"Austerity is not enough, even for budgetary discipline, if economic activity does not pick up a decent rate of growth. "|
Italy's Mario Monti agrees with Angela Merkel in opposing more intervention by the European Central Bank, but has urged an expansion of the EFSF, and he has said that "stability bonds ... might actually make a contribution but it must be done within a fiscal union
|"We ask that Germany admits that she is the biggest beneficiary of the current arrangements and therefore that she has the biggest obligation to make them sustainable"|
On a visit to Berlin on 28th November, the Polish Foreign Minister called for immediate action to strengthen fiscal coordination and to make the European Central Bank the eurozone's lender of last resort. Support for increased use of the European Central Bank was also expressed by Finnish and Belgian Ministers.
The Dutch Finance Minister has been quoted as saying "in the long term I do not exclude Eurobonds. But we have to do necessary things first. That means strict surveillance and enforcement of budgetary discipline".
- Alexandre Janiak and Etienne Wasmer: Mobility in Europe, European Commission, 2008
- Alfonso Arpaia and Karl Pichelmann: Nominal and real wage flexibility in EMU, European Commission, 2007
- Emmanuel Dhyne, Jerzy Konieczny, Fabio Rumler and Patrick Sevestre: Price Rigidity in the Euro Area, European Commission, 2009
- Clas Wihjborg.Thomas Willett and NanZhang: The Euro Debt Crisis. It isn't just fiscal, World Economics, October-December 2010 (figures 3-6)
- One market, one money. An evaluation of the potential benefits and costs of forming an economic and monetary union, European Economy, No 44 October 1990
- A centerless eurozone cannot hold, Kenneth Rogoff, Project Syndicate, April 2012
- Daniel Gros and Thomas Mayer: Refinancing the EFSF via the ECB, CEPS 18 August 2011
- Decision of the Governors of the European Central Bank of 2 July 2009 on the implementation of the covered bond purchase programme, (ECB/2009/16) European Central Bank
- ECB decides on measures to address severe tensions in financial markets European Central Bank, 10 May 2010
- Ramya Jaidev: Cracks emerge over ECB’s bond purchases, Central Banking, 11 May 2010
- Jean-Claude Juncker and Giulio Tremonti: E-bonds would end the crisis, Financial Times, December 5 2010
- Jacques Delpla and Jakob von Weizsäcker: The Blue Bond Proposal, bruegelpolicybrief, Bruegel Institute, May 2010
- Hans-Joachim Dübel: Partial sovereign bond insurance by the eurozone: A more efficient alternative to blue (Euro-)bonds, CEPS Policy Brief No. 252, August 2011
- [Olli Rehn: Eurobonds: Stability and Growth for the Euro Area, speech to the European Parliament, 10 January 2012
- Stijn Claessens, Ashoka Mody and Shahin Vallée: Paths to eurobonds, Breugel, 3rd July 2012
- Green Paper on the feasibility of introducing Stability Bonds, European Commission, 23 November 2011
- Wolfgang Münchau: Fiscal union is crucial to the euro's survival, Financial Times, November 14 2010
- The fiscal solution, Buttonwood's Notebook, The Economist, Nov 29th 2011
- EU breaks taboo, talks of Greek debt restructuring, Reuters, May 17, 2011
- Eight banks fail EU stress test with 16 in danger zone, BBC News, 15 July 2011
- A banking union for Europe, European Commission - 26/06/2012
- A Roadmap towards a Banking Union, European Commission, 12 September 2012
- Stephane Deo, Paul Donovan Sophie Constable and Larry Hatheway: How to break up a monetary union, Global Economic Perspectives, UBS Investment Research, February 2011
- Sam Fleming: Devastating price of euro failure, Times, 7 September 2011
- Anatole Kaletsky: A euro without Germany? Don’t bet against it, The Times, 14 September 2011
- J. Bradford DeLong: The ECB’s Battle against Central Banking Project Syndicate, 31 October 2011
- ECB 'conflict' over help for Irish banks, RTE News, 14 June 2011
- It Is Not Important Which Nation Puts Forward the ECB President, Interview with Axel Weber, Spiegel, 14 February
- Mario Draghi: Statement to the European Parliament, December 1 2011
- Draghi shelves the big bazooka, Financial Times, 8 December 2011
- Angela rules the roost, PressEurop press review, 24 October 2011
- Germany at Odds with Partners over Euro Crisis, Spiegel 23 January 2012
- Alan Beattie: Lagarde calls for bigger eurozone firewall, Financial Times, 23 January 2012
- Angela Merkel Europe must become a stabilisation union," Die Bundesregierung, 26 October 2011
- Angela Merkel once again rejects eurobonds, Die Bundesregierung, 23.11.2011
- German Resistance to Pooling Debt May Be Shrinking, SpiegelOnline 24 November 2011
- Bloomberg/YouGov eurozone crisis poll, YouGov August 2011
- Big losses for Merkel in German state elections, CNNworld, 27 March 2011
- Germany: Pirate Party Erodes Popularity Of Merkel's Coalition - Poll, Wall Street Journal, September 28 2011
- Leigh Phillips: Majority of French oppose fiscal treaty, EUobserver, 15 December 2011
- Joint Press Conference: Ms. Angela Merkel, Mario Monti and Mr. Nicolas Sarkozy, 24 November 2011
- Will the euro survive?, BBC News, 28 November 2011
- Dutch FinMin Sees Chances Of Eurobonds: Report, Forex Journal, 29 November 2011