Institutions of Macroeconomic Policy Jeffrey Frankel Harpel Professor Advanced Workshop on Global Political Economy, Institute as long as Global Law & Policy, Harvard Law School Lecture III, June 1, 2012 The Euro Crisis Was European Monetary Union a bad idea from the start Seven mistakes by euro leaders 7 mistakes made by euro leaders

Institutions of Macroeconomic Policy Jeffrey Frankel Harpel Professor Advanced Workshop on Global Political Economy, Institute as long as Global Law & Policy, Harvard Law School Lecture III, June 1, 2012 The Euro Crisis Was European Monetary Union a bad idea from the start Seven mistakes by euro leaders 7 mistakes made by euro leaders www.phwiki.com

Institutions of Macroeconomic Policy Jeffrey Frankel Harpel Professor Advanced Workshop on Global Political Economy, Institute as long as Global Law & Policy, Harvard Law School Lecture III, June 1, 2012 The Euro Crisis Was European Monetary Union a bad idea from the start Seven mistakes by euro leaders 7 mistakes made by euro leaders

Galvin, Nat, General Manager has reference to this Academic Journal, PHwiki organized this Journal Institutions of Macroeconomic Policy Jeffrey Frankel Harpel Professor Advanced Workshop on Global Political Economy, Institute as long as Global Law & Policy, Harvard Law School Lecture III, June 1, 2012 The Euro Crisis Was European Monetary Union a bad idea from the start Seven mistakes by euro leaders Appendices: Looking as long as ward Was European Monetary Union a bad idea from the start Pros: Monetary: A firm nominal anchor to end inflation among Mediterranean countries. Trade: To promote EU economic integration. Political: To improve cohesion. Cons: Monetary: Loss of ability by each to respond to local conditions by adjusting money supply, interest rate, or exchange rate. Political (according to M.Feldstein): Could lead to conflict.

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The major grounds as long as ex ante skepticism among (American) economists The euro countries did not meet the criteria of an Optimum Currency Area OCA: Bob Mundell, 1961 (another Nobel Prize). Individual members would be hit by individual (“asymmetric”) shocks. Lacking the high labor mobility of the US, where workers adjust to unemployment by moving across states, euro members would find it very difficult to abide by a common monetary policy. E.g., when a periphery country suffered a loss in dem in addition to , the interest rates set in Frankfurt would be too high as long as it. Comments on “The euro: It can’t happen, It’s a bad idea, It won’t last. U.S. economists on the EMU, 1989-2002,” by Jonung & Drea. Euro at 10, 2009 ASSA mtgs. In retrospect, economists were correct to worry about “asymmetric shocks” But (1) the shocks were excessive credit-fueled booms in the periphery countries (2003-07), rather than recessions, with Irel in addition to & Spain unable to raise interest rates or appreciate; in addition to (2) the booms showed up in asset prices (housing) more than in goods market inflation. (3) Only after the Global Financial Crisis began in 2008 was the need felt to fight recession with depreciation E.g. Pol in addition to had the best per as long as mance, the Baltics had the worst. And only after the Greek crisis began in Oct. 2009 did the need to devalue become so acute as to prompt thoughts of leaving the euro. But the Maastricht Treaty (Dec. 1991) focused on fiscal criteria as qualifications as long as euro membership: BD < 3% of GDP & Debt < 60% of GDP. One might have thought that, giving up the instrument of monetary policy, it would become more important as long as countries to retain the instrument of fiscal policy. Why did the designers of Maastricht emphasize fiscal criteria Theory I: Jason & the Golden Fleece Theory II: Theseus & the stone Theory III: Odysseus & the sirens. Frankel, Economic Policy (London) 16, April 1993, 92-97. The motivation as long as the Maastricht fiscal criteria was the same as as long as the No Bailout Clause in addition to the Stability & Growth Pact (1997): Skeptical German taxpayers believed that, be as long as e the € was done, they would be asked to bail out profligate Mediterranean countries. European elites adopted the fiscal rules to render these fears were groundless. 7 mistakes made by euro leaders Admitting Greece to the € in the first place, a country that was not yet ready by the relevant criteria. Pretending to en as long as ce the fiscal criteria. Allowing Mediterranean countries’ bond spreads near 0 helped by investors’ under-perception of risk (2003-07) in addition to artificial high credit ratings. But also ECB acceptance of Greek bonds as collateral. Burying their heads in the s in addition to when the crisis hit in late 2009: In early 2010, sending Greece to the IMF was “unthinkable.” In early 2011, restructuring of the debt was “unthinkable.” The current strategy: austerity as long as now, unen as long as ceable “Fiscal Compact” as long as the future. After the euro came into existence it became clear the German taxpayers had been right in addition to the European elites had beene wrong. E.g., Greece persistently violated the 3% deficit rule. All members violated the rules at some time, large & small. SGP targets were “met” by overly optimistic as long as ecasts. SGP threats of penalty had zero credibility. Yet each year the ostrich elites stuck their heads deeper & deeper into the s in addition to s. The Greek budget deficit never got below the 3% of GDP limit, nor did the debt ever decline toward the 60% limit Even Greece’s primary budget deficit has been far in excess of 3% since 2008 Source: IMF, 2011. I. Diwan, PED401, Oct. 2011 Spreads as long as Italy, Greece, & other Mediterranean members of € were near zero, from 2001 until 2008. Market Nighshift Nov. 16, 2011 When PASOK leader George Pap in addition to reou became PM in Oct. 2009, he announced that “foul play” had misstated the fiscal statistics under the previous government: the 2009 budget deficit 3.7%, as previously claimed, but > 12.7 % ! Missed opportunity The EMU elites had to know that someday a member country would face a debt crisis. In early 2010 they should have viewed Greece as a good opportunity to set a precedent as long as moral hazard: The fault egregiously lay with Greece itself, unlike Irel in addition to or Spain, which had done much right. It is small enough that the damage from debt restructuring could have been contained at that time. They should have applied the familiar IMF as long as mula: serious bailout, but only conditional on serious policy re as long as ms & serious Private Sector Involvement.

But the ostriches stuck their heads ever further down in the s in addition to . Eventually Greece, Irel in addition to in addition to Portugal went to the IMF; in addition to Greek debt was restructured. But by then interest rates in addition to debt/GDP ratios were far higher, it was too late to draw a line credibly distinguishing Greece from the others, even Spain in addition to Italy. Any solution to the euro crisis must include: (i) a way of putting the member countries back on sustainable paths ( debt/GDP declining). (ii) a way of preventing repeats in the future. As the Maastricht architects knew all along, this means a way of preventing fiscal moral hazard: preventing individual countries from running big deficits & debts, expecting to be bailed out in the event of a crisis. (i) Putting countries back on sustainable paths The 6th mistake: the German belief that fiscal contraction is expansionary. It is the same mistake made now by the UK & some in the US, in addition to is the same mistake made in 1937. As a result, Debt/GDP ratios in euro countries are rising, not falling; = the definition of unsustainable financially, even if you thought the economic hardship was sustainable politically.

(ii) Preventing moral hazard in the future The 7th mistake is Merkel’s “fiscal compact”: yet another unen as long as ceable declaration of determination to strengthen the SGP, via budget limits in national laws/constitutions. Why should these rules be any more credible than those that came be as long as e EMU Ostrich References by the speaker “The Hour of the Technocrats,” Project Syndicate, Nov.15, 2011. “The ECB’s Three Big Mistakes,” VoxEU, May 16, 2011. “Optimal Currency Areas & Governance”, slides session on the Challenge of Europe at the Annual Conference of George Soros’ INET, April 2011; video available, including my presentation. “Let Greece Go to the IMF,” Jeff Frankel’s blog, Feb.11, 2010. Over-optimism in Forecasts by Official Budget Agencies in addition to Its Implications,” Ox as long as d Review of Economic Policy, 2011. “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” Fiscal Policy in addition to Macroeconomic Per as long as mance, Central Bank of Chile, 2011. NBER WP 16945, April 2011. “The Estimated Effects of the Euro on Trade: Why are They Below Historical Evidence on Effects of Monetary Unions Among Smaller Countries” in Europe in addition to the Euro, Alberto Alesina & Francesco Giavazzi, eds. (U.Chic.Press), 2010. “Comments on ‘The euro: It can’t happen, It’s a bad idea, It won’t last. U.S. economists on the EMU, 1989-2002,’ by L.Jonung & E.Drea,” slides. Euro at 10: Reflections on American Views, ASSA meetings, San Francisco, 2009. “The UK Decision re EMU: Implications of Currency Blocs as long as Trade in addition to Business Cycle Correlations,” in Submissions on EMU from Leading Academics (H.M. Treasury: London), 2003. “The Endogeneity of the Optimum Currency Area Criterion,” with Andrew Rose, The Economic Journal, 108, no.449, July 1998. “‘Excessive Deficits’: Sense in addition to Nonsense in the Treaty of Maastricht; Comments on Buiter, Corsetti in addition to Roubini,” Economic Policy, Vol.16, 1993.

Appendices: (A) In the US system, how do the fiscal policies of the 50 states avoid moral hazard (B) The ECB’s LTROs (Dec. 2011-Feb 2012) (C) Any solution as long as the long term (D) Restoring competitiveness via the exchange rate: Pol in addition to vs. the Baltics Appendix A: Perhaps the Fiscal Compact misunderst in addition to s the US system Yes, despite a common currency, the 50 states do not seem to have moral hazard: The federal government has never bailed one out, in addition to nobody expects it to now. But that is not due to the budget rules that (49 of) the states have. Their rules are voluntary, varied, in addition to flexible. Some states do have debt troubles, in addition to even default. How the US avoids moral hazard in the 50 states Government spending at the state level is a far smaller share of income than at the federal level, let alone on the part of European states. Is Europe ready as long as that No. When one state begins to run its debt too high, the private market automatically imposes an interest rate penalty. E.g., Cali as long as nia today. Gives states the incentives to get back in line. This mechanism was expected to operate in eurol in addition to Alesina, et al (EP, 1992) in addition to Goldstein & Woglom (1992). but conspicuously failed from the first day. Which showed that moral hazard had not been addressed.

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Nobody expects the U.S. Federal government to bail out indebted states: The precedent was set 170 years ago, when 8 states were allowed to default. When States Default: 2011, Meet 1841, WSJ In the early 1940s, 5 states repudiated their debts completely (Michigan, Mississippi, Arkansas, Louisiana & Florida) while a few more were in default as long as several years. Spreads help keep profligate US states in line. Cali as long as nia Municipal Bonds (now the lowest rated of the 50 states) Credit Default Swaps http://blogs.reuters.com/munil in addition to /2011/06/08/muni-sweeps-lockyer-rides-again/ Appendix B: Mario Draghi became President of the ECB, Nov.1, 2011 He was under intense pressure to exp in addition to his predecessor’s purchases of large quantities of periphery-country bonds. The ECB was urged to be the “big bazooka”: to buy troubled governments bonds. If the ECB interpreted its m in addition to ate literally, as no more than keeping inflation low, then the euro might break up. On the other h in addition to , as Draghi knew: the ECB is legally prohibited from financing governments directly; If he had bailed out Italy & the others, he would have: facilitated a continuation of Berlusconi-style irresponsibility; been immediately written off by Germans as another profligate Italian.

Draghi’s LTRO (Longer-Term Refinancing Operation) was a great success. On Dec. 22, he caught everyone by surprise by the clever ploy of doing exactly what he had previously announced he would do: loans to banks as long as 3 years, at low interest. High take-up Brought down interbank & country spreads, while consistent with central bank LoLR m in addition to ate. 2nd round in late February was equally successful. But the LTRO rounds were not a solution; They only bought a little time. Appendix C: Proposal as long as the long term 1 Emulate Chile’s successful fiscal institutions: Give responsibility as long as determining what is a structural deficit in addition to what is a cyclical deficit to an independent professional agency, to avoid as long as ecast bias. (Frankel, 2012) Proposal as long as the long term 2 Penalty when a euro country misses its target: The ECB then stops accepting new bonds as collateral. => Sovereign spread rises, with automaticity. Proposal from Brueghel (JvW & ZD): All of eurol in addition to is liable as long as blue bonds (issued up to SGP limits); Issuing country is liable as long as red bonds (beyond those limits) . Blue bonds share advantages with other eurobond proposals: ECB can conduct monetary policy. They could offer an alternative to US TBills as long as PBoC & other desperate global investors

Jeffrey Frankel Advanced Workshop on Global Political Economy, End of Lecture III The Euro Crisis

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