What’s Going On in the Euro Zone?

NYU International Business Association

Lunch Talk, October 10, 2012

David Backus, New York University

dbackus@stern.nyu.edu

Economics at NYU

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2

The Euro Zone

• What is the EZ?

• What’s going on there?

3

Classic crisis triggers

Crisis triggers

• The classic crisis triggers

– Sovereign debt (“debt crisis”)

– Financial system weakness (“financial crisis”)

– Fixed exchange rates (“exchange rate crisis”)

• What about Europe?

5

Europe

• Our challenge: find a coherent story for a huge mess

• My take

– Sovereign debt problems in Greece, Portugal, Spain, Italy…

– Banking problems in Ireland, Spain, …

– “Enabled” by Euro Zone

6

The European Union

Europe and the Euro Zone

• European Union emerged from wreckage of WW II

– Closer economic ties to connect countries, maintain peace

• Short history

– Paris Treaty (1951): coal and steel community

– Treaty of Rome (1957): more extensive free trade zone

– Continued integration and expansion to the present

• The Euro Zone

– Maastricht Treaty (1993) established ground rules, ECB

– Euro launched Jan 1 1999 with 11 countries, now has 17

8

The Euro Zone is different

9

Common? US EU

Currency Yes Yes

Deposit insurance Yes No

Bank regulation Yes No

Fiscal policy Yes No

Political authority Yes No

Language Yes No

Olympic team Yes No

Army Yes No

Overview

Government debt (% of GDP)

11

0

20

40

60

80

100

120

140

160

180

France Germany Greece Italy Spain

2000 2011

Source: EIU, CountryData.

Long-term government interest rates

12Source: ECB, statistical data warehouse.

0

5

10

15

20

25

30

35Ja

n-0

8

Ap

r-08

Jul-

08

Oct

-08

Jan

-09

Ap

r-09

Jul-

09

Oct

-09

Jan

-10

Ap

r-10

Jul-

10

Oct

-10

Jan

-11

Ap

r-11

Jul-

11

Oct

-11

Jan

-12

France Germany Greece Italy Spain

Long-term government interest rates

13Source: ECB, statistical data warehouse.

0

1

2

3

4

5

6

7

8Ja

n-0

8

Ap

r-08

Jul-

08

Oct

-08

Jan

-09

Ap

r-09

Jul-

09

Oct

-09

Jan

-10

Ap

r-10

Jul-

10

Oct

-10

Jan

-11

Ap

r-11

Jul-

11

Oct

-11

Jan

-12

France Germany Italy Spain

GDP growth

14Source: ECB, statistical data warehouse.

-8

-6

-4

-2

0

2

4

6

8

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

France Germany Greece Italy Spain

Case studies

Greece

• What’s happening in Greece?

16

Greece: government debt (% of GDP)

17Source: EIU, CountryData

0

20

40

60

80

100

120

140

160

180

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Greece: government surpluses (% of GDP)

18Source: EIU, CountryData

-20

-15

-10

-5

0

5

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Total Primary

Greece

• What’s happening in Greece?

– Large government debt, suspect financial statements

– Continuing deficits (high spending, poor tax collection)

– Sharp rise in rates makes debt unsupportable

• Questions

– Why were they able to sell debt at such low rates?

– Why continued deficits in 2009-2012?

– Are endless negotiations worse than “cold turkey”?

– Would devaluation have helped?

19

Spain

• What’s happening in Spain?

20

Spain: government debt (% of GDP)

21Source: EIU, CountryData

0

10

20

30

40

50

60

70

80

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Spain: government surpluses (% of GDP)

22Source: EIU, CountryData

-12

-10

-8

-6

-4

-2

0

2

4

6

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Total Primary

Spain

• What’s happening in Spain?

– Modest debt and deficits prior to crisis

– Global downturn hit revenue hard, led to large deficits

– Larger housing boom and bust than most

– Problems with regional governments and “cajas” feeding back on sovereign debt

• Questions

– Can government recapitalize financial system without bankrupting itself?

– Will regional tensions make agreement impossible?

23

Italy

• What’s happening in Italy?

24

Italy: government debt (% of GDP)

25Source: EIU, CountryData

90

95

100

105

110

115

120

125

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Italy: government surpluses (% of GDP)

26Source: EIU, CountryData

-6

-4

-2

0

2

4

6

8

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Total Primary

Italy

• What’s happening in Italy?

– Large debt prior to crisis, but deficits modest and primary balance is in surplus

– Problem is growth: B/Y stuck high because Y is stalled

– Rigid labor markets, other economic frictions, hurting growth

– Widely regarded as best case among troubled countries

• Questions

– What will it take to restart economic growth?

27

The Euro Zone as “enabler”

Problem #1

• Lack of fiscal discipline

• Fiscal criteria in Maastricht Treat abandoned early on

• Not credible anyway?

• Would a US-like system have worked better?

29

Problem #2

• Leaks in the payments system

• “IMF without conditionality”

30

Target2 balances

31

Problem #3

• National bank regulation and deposit insurance

• A recipe for cross-border bank runs

32

Problem #4

• Regulators gave all member debt zero risk weight

• Greek debt less risky than British debt!

• Obvious play: buy Greek debt, use as collateral for ECB loan

33

Problem #5

• No exit strategy

• Gives weak countries excessive leverage

• Why give Greece a gun?

• Is Ecuador a better model?

34

Problem #6

• Cumbersome political process for fiscal coordination

• Remember: political authority not centralized

• Why do we care what Finland thinks?

• The OMT/EFSF/EMS Rube Goldberg machine is on its way

35

Rube Goldberg machine

36

Problem #7

• Europeans associate themselves with countries, not Europe

• The United States: plural or singular?

37

Where now?

Problems – and progress

• Problems

– Common currency hard to do right

– Governance slow and cumbersome, esp fiscal actions

– Clear cost in terms of performance (Mexico v. Greece)

• Still: remarkable progress along many fronts

– Fiscal discipline catching on in most places

– OMT/EFSF/EMS shows coordination isn’t impossible

– Common bank regulation under discussion

– Odds of success? What would success look like?

39

Open questions

• Will mismatch between common currency and national political authority emerge in other ways?

• Do members want integration or sovereignty?

40

Lessons for others

• Common currency has great symbolic value

• But hard to do right

• Also a huge distraction from bigger issues

• Like productivity

41

Extra slides

Mexico: budget balance (% of GDP)

43Source: EIU, CountryData

-2

-1

0

1

2

3

4

5

1991 1992 1993 1994 1995 1996 1997 1998 1999

Mexico: GDP growth (%)

44Source: EIU, CountryData

-8

-6

-4

-2

0

2

4

6

8

1991 1992 1993 1994 1995 1996 1997 1998 1999

Greece: budget balance (% of GDP)

45Source: EIU, CountryData

-18

-16

-14

-12

-10

-8

-6

-4

-2

0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Greece: GDP growth (%)

46Source: EIU, CountryData

-8

-6

-4

-2

0

2

4

6

8

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012