Transcript Reserve Uncertainty and the Supply of International Credit

A plenary address
European Integration:
Past, Present & Future
Wilfrid Laurier University (WLU)
European Integration: a work in progress
(regress?)
Joshua Aizenman; UCSC and the NBER
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1 January 2009 -- the 10th
anniversary of the euro and of the
Euro system.
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Exactly ten years before the euro was
introduced, first as an electronic means of
payment (the banknotes and coins came into
circulation in 2002).
In 2008, the accomplishments of the Euro were
celebrated in several major conferences.
Overall, the continental European view reflected
growing satisfaction with the achievements.
On the short history of the Euro
project
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The drivers of the Euro project were the core
of “Old Europe” – France and Germany.
Skeptical views from the US.
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Concerns (beyond the fact that stronger € may
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reduce global demand for $):
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The Euro project is a currency union, without
political and fiscal unification.
The Euro zone fails conventional ‘Optimal
currency union’ criteria:
The case for ‘Optimal currency
union’ is stronger when
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Labor Mobility (LM) is high, thereby
substituting for the inability to adjust the
exchange rate between Germany and
(Greece, Spain, Portugal, Ireland, etc), or
between California and Texas.
Fiscal Unification (FU) is high, providing
implicit insurance by a federal tax and grant
system.
Trade within the Monetary union is high.
The US meets these criteria more than the
Euro block.
In the absence of strong LM
and FU
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Symmetry of shocks and structure helps by
reducing the gain from independent monetary
policy.
US economists were skeptical about the
economic case for Euro [Feldstein, Obstfeld,
Rogoff, among others].
Yet, time may help, and inefficient monetary
union may mature into an efficient one [J.
Frankel, see Frankel and Chinn on the $ and
Euro future].
The first decade of the Euro:
good luck helped…
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“Great moderation,” tranquil time, regional and
global growth helped in masking burgeoning
problems in the Euro block [in the US…].
The illusive “great moderation” intensified
unsustainable trends in the weaker underbelly of
the Euro block (large and growing current
account deficits, and unsustainable housing
booms in several countries).
The crisis: the first serious test of the Euro
project (as well as of financial globalization).
The outcome: murky.
Unemployment rates
15%
23%
13%
13%
19%
10%
ECB's Weber says ECB in a state of
'heightened alertness' on inflation risks,
June 12, 2008 Thomson Financial News
ECB Governing Council Member Axel Weber said the ECB
is in a state of 'heightened alertness' and is ready to act
given the continuing strong upside risks to price stability.
 In a keynote speech in Munich, Weber also said the
ECB will continue to provide liquidity to the Euro
money market given the ongoing tensions in the
longer-term sector but does not 'offer some sort of expost insurance to financial market participants who
have engaged in excessive risk-taking'.
http://www.forbes.com/feeds/afx/2008/06/12/afx5108529.html
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The Greek crisis is testing the
stability and the dispute
resolution capacity of Euro block
Selective contagion?
Most OECD facing fiscal
challenges, including the € block
These challenges are the legacy of
the welfare state at times of declining
fertility and economic growth.
 In due course, fiscal tightening will
face most OECD, scaling down some
of the transfers (making them more
progressive, switching to means
tested benefits), and possibly higher
taxes.
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Current &
future
government
obligations/
GDP.
Source:
NYT, 3-12-2010
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The road ahead
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I.
II.
III.
Three possible scenarios, ordered by
desirability (and hopefully, by
plausibility…).
The Euro block will muddle through.
Due to political reasons, Greece will exit
the Euro.
The core of Euro will survive (assuming
France and Germany would remain committed to
the Euro project). Greece’s exit would induce
contagion, and possible exit of several
weaker members.
I. The Euro block and Greece
will muddle through
Stabilization package, probably facilitated
via the IMF.
 Conditionality (fiscal tightening) in
exchange for debt restructuring (longer
term debt, possibly with “hair cuts”).
 Serious fiscal adjustment of the weaker
“southern-belly” of Europe.
 Germany and France would support the
stabilization [fear of multiple equilibria].
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For France and Germany, ‘bailing out’ Greece is
akin to bailing out their own banking systems…
French & German banks are exposed to Greek bonds, (58, 32) € BN
II. Greece will exit the Euro
block ?
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Internal politics in Greece may induce
populist pressure to exit the euro block.
A large depreciation to facilitate adjustment, probably
large Greek default on € debt overhang.
Exiting the € is not a panacea (see Argentina’s
experience--massive banking crisis, inflationary
pressure, redistribution of income). At best, modest
short term gains, no fix for the need to cut
overspending.
Adverse impact on the soft southern-belly of the Euro
block (contagion would increase the risk premium).
With luck, the net effect on the remaining Euro block
may be modest [Greece counts for 3% of Euro block’s
GDP, 11 million residents].
III. The core of Euro will survive
Exit of Greece may lead to a chain
reaction, inducing exit of other weak
countries.
 It may derail the extension of the Euro
project, scaling down the prospect
that the Euro will overtime become a
global currency that will challenge the
US dollar.
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Dynamic implications of the
crisis
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The crisis will induce tightening of fiscal rules
within the Euro block, leading to gradual
convergence of taxes, retirement age,
etc…(delaying retirement to 60+, increasing tax
collection in weaker countries, etc).
While fiscal unification is not in the cards for the
next decade(s), tighter fiscal monitoring would
emerge in order to mitigate exposure to a replay
of the unfolding Greek tragedy.
These adjustments will induce de-facto fiscal
convergence.
Moral hazard: the global crisis, and the Greek
fiasco exposed the need to tighten banking
regulations
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Banks and big financial intermediaries
expose the tax payer to moral hazard
associated with the ‘too big to fail’ doctrine.
Greek default would require domestic bailouts
in European countries whose banks are
heavily exposed to Greek bonds [French &
German banks are exposed to Greek bonds,
(58 € BN, 32 € BN ) respectively].
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The remedy: ex ante monitoring and
supervision of banks’ riskiness, charging a risk
premium based on banks’ portfolio’s risk, and
funding future bailouts (akin to FDIC’s policy).
To put it into proper
perspective
The US dollar started mostly as currency
union among states, with scanty fiscal
unification.
 It took about 200 years for the dollar union
to reach the present stage of fiscal and
political unification of 50 states.
 The process was ugly [Civil War, Great
Depression, etc].
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Fiscal Federalism in the US
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http://www.gpoaccess.gov/usbudget/fy11/hist.html
http://usgovernmentspending.blogspot.com/
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Concluding remarks
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Successful muddling through the crisis in
Europe would induce the Euro block to deal
with hidden challenges that were unmasked by the
crisis.
The global crisis & the Greek/€ crisis illustrate the
Paradox of Regulation [Aizenman, NBER WP # 15018]
While the identity of economic agents that benefit
directly from crisis avoidance is unknown, the cost
and the cumbrance of regulations are transparent.
Hence, crises that have been avoided are
imperceptible and are underrepresented in the
political discourse.
The success of the prudential regulator or a
prolonged period of economic tranquility lead to
complacency, reducing the demand for regulator’s
services, inducing under regulation, which leads to
a financial calamity.
Concluding remarks II
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The quality of the adjustment of all the
participants would profoundly impact the
future of the Euro, the speed of
extending its reach to Eastern Europe,
the global recovery, and the role of € as
an international reserve currency.
"The news of the € death has been greatly
exaggerated."
Thanks for your attention
Internet sources
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http://www.ft.com/cms/s/0/8038d17e-167d-11df-bf44-00144feab49a.html#
http://www.marketoracle.co.uk/images/Greece_Economy.jpg
http://si.wsj.net/public/resources/images/OB-HR858_greece_G_20100226231010.jpg
http://graphics.thomsonreuters.com/0210/EZ_DBTPH0210.gif
http://www.marketoracle.co.uk/images/2010/Feb/euro-18_image006.jpg
http://media.economist.com/images/20100220/201008EUC041.gif