Transcript Optimal Currency Areas & Governance: The Challenge of Europe Jeffrey Frankel Harpel Professor, Harvard University 2011 Annual Conference, Bretton Woods NH, April 10

Optimal Currency Areas & Governance:
The Challenge of Europe
Jeffrey Frankel
Harpel Professor, Harvard University
2011 Annual Conference, Bretton Woods NH, April 10
The framework of Niels Thygesen’s paper
1970 – The issues according
to the original Optimum Currency Area theory
– esp. Mundell & McKinnon.
1990 – The issues as they appeared
to those drafting the Maastricht Treaty (1991).
– esp. the Delors Report (1989) & One Market, One Money (1990).
2010 – The issues as they appear
in light of recent developments,
– esp. the sovereign debt crisis of the periphery.
2011: Is Europe making the right reforms in governance?
1970 – The issues
according to the original OCA theory
For the gains of a common currency to be worth
the cost of giving up independent national
monetary policies, the countries must have:
–
–
–
–
“Symmetry”
(≡ high correlation of shocks)
Labor mobility (across both borders and jobs)
A system of fiscal transfers (countercyclically)
Openness (a high ratio of tradable goods to GDP).
The early concerns of many American skeptics:
– Europe lacks most of these OCA requirements.
1990 – The issues as they appeared
to those drafting the Maastricht Treaty (1991).
“…the background had changed remarkably.
The implicit advice from the OCA checklist seemed
less relevant, partly because it was… [more] likely
to evolve favorably after introducing a common
currency than before.”
Some research seemed to validate this judgment:
– Monetary unions boost trade a lot
Rose (2000): “One Money, One Market”
– => Cyclical correlation rises in turn
Frankel & Rose (1997,98): “Endogeneity of the OCA Criteria”
vs. Eichengreen (1992) and Krugman (1993) .
– Also, labor markets will be forced to become more flexible
Roubini…
1991 emphasized new issues instead
Prof. Thygesen lists the desire to address $ instability,
and some others.
I would, rather, point to the heart
of the “Maastricht criteria:”
ceilings on budget deficit (3%) & debt/GDP (60%).
– Fiscal criteria had not appeared anywhere in OCA theory.
One might have said, rather, that loss of the national monetary
instrument made a free fiscal instrument more important.
– Some economists found them incomprehensible.
E.g. Buiter, Corsetti & Roubini (1993).
Some speculated on what the Germans’ real motivation was.
– E.g., a golden fleece.
But the motivation
for the Maastricht fiscal criteria is clear
as for the No Bailout Clause
and the Stability & Growth Pact (1997):
Skeptical German taxpayers believed that,
before the € was done, they would be asked to
bail out profligate Mediterranean countries.
European elites adopted the fiscal rules to
demonstrate that these fears were groundless.
After the euro came into existence
it became clear that the German taxpayers were right
– and the European elites were wrong.
E.g., Greece, even on the distorted budget figures
it submitted, never satisfied the 3% rule
in any single year after joining.
The large countries violated the rule too.
SGP targets were “met” by overly optimistic forecasts.
SGP threats of penalty had zero credibility.
Yet each year the ostrich elites stuck
their heads deeper & deeper into the sands.
2010 – Lessons
from the sovereign debt crisis
Thygesen:
– Responsibility for financial stability cannot remain
exclusively at the national level.
– The same for fiscal stability.
– I agree.
But I do not agree that the official responses
have been the right ones.
I agree, rather, with Darvas, Pisani-Ferry & Sapir:
– Officialdom has been “reactive rather than proactive,”
– treating insolvency as illiquidity.
Revisions in
EMU governance
Fiscal rules “will become more explicit and will be
monitored more tightly.”…
– Weaknesses in the SGP “are now being addressed.”
“Structural reforms…will be monitored closely by the EC.”
EU-level supervision of financial institutions,
& European Systemic Risk Board (ESRB).
Permanent European Stability Mechanism (ESM)
for crisis bailouts.
– “The loans to Greece in May 2010 and to Ireland…
[were] regarded as constructive by most critics.”
My reaction
The ostriches have
stuck their heads
down in the sand
so far that they
have popped up on
some other planet.
There is even less reason now to think the SGP
will work than there was the first time around.
European elites’ mistakes
in managing the Greek debt problem
Admission of Greece to the euro in the 1st place.
ECB acceptance of Greek bonds as collateral
– despite high debt & deficits.
– => investors charged near-zero spreads,
helped by artificial high credit ratings.
Failure to send Greece to the IMF in early 2010.
Refusal to think about the likely
need for restructuring of the debt.
Spreads for Greece & other Mediterranean members
of € were near zero, from joining until 2008
Council on Foreign Relations
Spreads help keep profligate US states in line
as we saw in Carl-Ludiwg Holtfrerich’s paper
Yield to
maturity
in %
Source: W.B. English, „Understanding the costs of sovereign default …,“ p. 269. as used by Holtfrerich
(2011)
13
What alternative fiscal reforms, then?
taking as given that German taxpayers will
not allow a fiscal union now more than ever.
Proposal:
1. The SGP should emulate Chile’s
successful fiscal institutions (Frankel, 2011):
a) Phrase the budget target in structural terms.
b) Give responsibility for determining what is structural to an
independent professional agency, to avoid forecast bias.
2.
Penalty when a country misses its target:
a) The ECB then stops accepting its bonds as collateral.
b) => Sovereign spread rises, with true automaticity.
EMU
Ostrich
References by the speaker
Over-optimism in Forecasts by Official Budget Agencies and Its
Implications," Feb.2011, written for symposium on Economic Borders of the
State in the Oxford Review of Economic Policy.
“A Solution to Fiscal Procyclicality: The Structural Budget Institutions
Pioneered by Chile,” forthcoming, Fiscal Policy and Macroeconomic
Performance, Series on Central Banking Analysis, and Economic Policies,
2011. NBER WP 16945, April 2011.
"Let Greece Go to the IMF," Jeff Frankel’s blog, Feb.11, 2010.
“The Estimated Effects of the Euro on Trade: Why are They Below
Historical Evidence on Effects of Monetary Unions Among Smaller
Countries?” in Europe and the Euro, edited by Alberto Alesina & Francesco
Giavazzi (U. Chicago 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, Jan.2009.
"The UK Decision re EMU: Implications of Currency Blocs for Trade and
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 and Nonsense in the Treaty of Maastricht;
Comments on Buiter, Corsetti and Roubini,” Economic Policy, Vol.16, 1993.