future of the Euromay 2015

for ten first years, euro is a big success:• 1st currency in the world for banknotes' use(value)• 2nd reserve currency in the world for foreignexchange reserves• "strong" exchange rate
• 2nd biggest financial market in the world• an area of price stability
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Euro bank notes

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then the crisis• first phase ( 2010) : Greece's unsustainablefinances• second phase ( 2011-2012) : peripheral"divergences" and internal convertibility doubts• third phase ( 2013 – 2015) : doubts on growthand deflation risk
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Three points of view
• The project was flawed from the start• The crisis was poorly managed• A "redesign" is necessary

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three points
1. does the project make (economic) sense ?
2. what are the weaknesses revealed by thecrisis ?
3. Progress and challenges ahead
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Currency union• Sharing the same currency• The same monetary policy• No exchange rate between participating
countries
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the "theory"• A currency union must rest upon :– Either full capital or labor mobility– Or a fiscal union as well

• Euro has neither• Therefore it must failjpl/may 2015

asymetric real shocks• Can be demand or supply• An asymmetric shock needs either
1. a change in the (real) exchange rate
2. or a move in the supply schedule : factor mobility
3. or a move in the demand schedule : factor
mobility and/or fiscal transfers
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an optimum currency area
• needs :– either full factor mobility– and/ or fiscal transfers• but geographical area does not necessarily
coincide with nations’ borders• Mundell “father of the Euro”
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the response• Some benefits not captured by the theory (financial stability)• The capital market will do the job• A good framework for fiscal policy : theGrowth and Stability Pactjpl/may 2015

convergence criteria and GSP• Convergence criteria– Inflation– LT interest rates– Budget balance• GSP– Deficit(3%) and debt(60%) criteria– Attempts to refine ( structural balance)– Attempts to enforce ( the procedure, themajorities)
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It worked for ten years• Capital markets looked as of they did the job :no instability; and capital flew from "north" to"south" fostering convergence anddevelopment• Fiscal framework was not respected but debt
was under control
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2. what are the weaknesses revealedby the crisis• Pre crisis– Imbalances were accumulating– Financial relationships were fragile• During the crisis– Disagreements between countries– Perverse political dynamics

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Imbalances were accumulatingjpl/may 2015

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source : Higgins and Klitgaard
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Financial relationships were fragile

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feedback loop

growthsovereigns

creditbanks

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we did not see that : the link
between sovereigns andbanks
growthsovereigns

creditbanks

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bond market

CAPITAL FLOWS – CURRENTACCOUNTs

growthsovereigns

sovereigns

growthcredit

banks

banks

creditInterbankmarketjpl/may 2015

cross border capital flows were fragile• mainly interbank and short term

• Fueled expansion of credit and bubbles

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source : Higgins and Klitgaard
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the crisis : a collapse of cross borderfinancial intermediation

source : Merler and Pisani Ferryjpl/may 2015

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during the crisis• initial shock– usually small when compared to ultimate consequences– total Greek public debt < 1.5% of euro area GDP• amplification mechanisms• possibly aggravated by misguided policy responses• revealing underlying vulnerabilities

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Financial
feedbackloop

doubts on
solvencyworse
solvency

Slower
growthhigher risk
premiaIncreaseinterest rates

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politicalfeedback loopdisagreements delays

situationworsens

nationalism

political
difficulties

larger financial
effort necessary

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3. Progress and challenges ahead• Stopping the feed back loops• Looking at the futurejpl/may 2015

stopping the feedback loop

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Quantitativeeasinggrowthstopping the feedback
loop

sovereigns

liquidity provisioncreditbanks

recapitalizationjpl/may 2015banks

Looking at the futurejpl/may 2015

currency unions and fiscal policies• the theory : fiscal coordination– to absorb asymetric shocks and mimic the federal
budget– To get the right policy mix• The policy– Skepticism towards keynesian based fiscal policies– The risk of free riding and implicit transfers: no bailout– The threat to monetary policy independance andeffectivenessjpl/may 2015

how do you absorb a fiscal shock ?

on your own

Ex antediscipline

default

with othermember statesfederalbudgetConditional
eurobonds
bail out

ESM
Treatyfinancialstability ?

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with theCentral Bank
moral
hazardinflationconclusion : the misguided search forclarity• “extreme” scenarios unlikely– No miraculous agreement on fundamental issues– No fiscal federalism– No general break up - ECB won’t allow it• Long period of “muddle through “
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