The Euro Crisis

1
The Euro Crisis Greece Five MistakesJeffrey
FrankelHarpel Professor

• Greek and European Debt Crisis panel,
• Harvard College Hellenic Society, 105 Emerson
  Hall, Harvard University, Dec. 6, 2011 

2

• 5 mistakes made by eurolands leaders regarding
  Greece
• Slender rays of hope
• The hour of the technocrats
• Proposals for the future

3
5 mistakes made by euro leaders

• Admitting Greece to the in the first place,
• a country that was not yet ready.
• Pretending to enforce the fiscal criteria
• BD lt 3 of GDP Debt lt 60 of GDP.
• Allowing Mediterranean countries bonds spreads
  near 0
• helped by investors under-perception of risk
  (2003-07)
• and artificial high credit ratings. But also
• ECB acceptance of Greek bonds as collateral.
• When the crisis hit, the leaders buried their
  heads in the sand
• 2 years ago, sending Greece to the IMF was
  unthinkable.
• 1 year ago, restructuring of the debt was
  unthinkable.

4
The Treaty of Maastricht (1991) surprised many
economists by emphasizing fiscal criteria as
qualifications for membership.

• Why did the designers do it?
• Theory I Jason the Golden Fleece
• Theory II Theseus the stone
• Theory III Odysseus the mast.

Frankel, Economic Policy (London) 16, April 1993,
92-97.
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The motivationfor the Maastricht fiscal criteria
is clear

• the same 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.

6
After the euro came into existence

• it became clear the German taxpayers had been
  right
• and the European elites were wrong.
• E.g., Greece persistently violated the 3 deficit
  rule.
• 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.

7
The Greek budget deficitnever got below the 3
of GDP limit,nor did the debt ever decline
toward the 60 limit
8
Spreads for Italy, Greece, other Mediterranean
members of were near zero, from 2001 until
2008.
Market Nighshift Nov. 16, 2011
9
When PASOK leader George Papandreou 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 gt 12.7 !

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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 for moral
  hazard
• The fault egregiously lay with Greece itself.
• Unlike Ireland or Spain, which had done much
  right.
• It is small enough that the damage from debt
  restructuring could have been contained at that
  time.
• Unlike Italy now, if the worst happens.
• They should have applied the familiar IMF
  formula serious bailout, but only conditional
  on serious policy reforms serious Private
  Sector Involvement.

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• But the ostriches stuck their heads ever
  further down in the sand.
• There is even less reason now to think Brussels
  can impose fiscal constraints on borrowers or ask
  unlimited transfers from creditor country
  taxpayers than before.

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Slender rays of hope, 1

• Greece, Ireland Portugal did finally go to the
  IMF Germany banks did finally agree to write
  down Greek debt.
• But it has always been much too little, too
  late.
• The only solution for the short-term
• a lot more money
• from ECB
• national governments,
• conditional on reforms PSI, country-by-country.

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Slender rays of hope, 2

• A government of technocrats under Mario Monti in
  Italy is a huge improvement over the disaster of
  Berlusconi.
• Similarly Lucas Papademos in Greece
• But he has been given even less freedom of
  action than Monti his term is only 3 months
  and he wasnt allowed to pick his cabinet.

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EMU
Ostrich
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References by the speaker

• The ECBs 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 Frankels blog,
  Feb.11, 2010.
• Over-optimism in Forecasts by Official Budget
  Agencies and Its Implications," 2011, forthcoming
  in Oxford Review of Economic Policy.
• A Solution to Fiscal Procyclicality  The
  Structural Budget Institutions Pioneered by
  Chile, Fiscal Policy and Macroeconomic
  Performance,  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 and the Euro, Alberto Alesina Francesco
  Giavazzi, eds. (U.Chic.Press), 2010.   
• "Comments on 'The euro It cant happen, Its a
  bad idea, It wont 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 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.  

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Appendix A The missing mechanism to discourage
over-indebtedness

• At the time of Maastricht, some economists had
  hoped that euro countries with deficits/debts
  would be kept in line, as U.S. states are,
• esp. by an automatic market rise in interest
  rates,
• with no expectation of federal bailout.
• Alesina, et al (EP, 1992) and Goldstein Woglom
  (1992).
• Why didnt that mechanism work?

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Spreads help keep profligate US states in line
reason why no state has ever been bailed out by
the Federal government, despite some defaults.
Yield tomaturity in
17
Source W.B. English, Understanding the costs of
sovereign default , p. 269. as used by
Holtfrerich (2011)
18
California Municipal Bonds(now the lowest rated
of the 50- states)Credit Default
Swapshttp//blogs.reuters.com/muniland/2011/06/08
/muni-sweeps-lockyer-rides-again/
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Appendix B Proposals for the future 1

• Emulate Chiles successful fiscal institutions
• Phrase budget targets in structural terms.
• Give responsibility for determining what is
  structural to an independent professional agency,
  to avoid forecast bias. (Frankel, 2011)

20
Even the primary budget deficithas been far in
excess of 3 since 2008
Source IMF, 2011.I. Diwan, PED401, Oct. 2011
21
Even though in most years true Greek budget
deficits were far in excess of the supposed
limit (3 of GDP).
the official budget forecasts were always rosy.
Until, in 2009, the bottom fell out of the budget.
Source Frankel Schreger (2011)
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Proposals for the future 2

• Penalty when a euro country misses its
  target
• The ECB then stops accepting new bonds as
  collateral.
• gt Sovereign spread rises, with automaticity.
• Proposal from Brueghel (JvW ZD) All of
  euroland is liable for blue bonds (issued up to
  SGP limits) Issuing country is liable for 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
  for PBoC other desperate global investors

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Blue bonds red bonds
Gavyn Davies, FT
Source