4/10/2011
POSSIBLE SCENARIOS FOR THE EUROPEAN MONETARY UNION 1
INTRODUCTION
Fundamental problem is the architecture of the European Monetary Union.
A currency union is only stable for as long as a single economic policy is pursued.
If this is not the case, it will sooner or later lead to friction among the members.
In the long-run, these tensions can only be resolved in two ways: either a collapse of the currency union or a proper economic integration of the euro zone.
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“OPTIMAL CURRENCY UNIONS”
Mundell 1961
An asymmetric shock is one which hits one member of the currency union but not the others.
External balance refers to the balance-of-payments equilibrium, while internal balance refers to full employment.
Mundell’s solution: factor mobility across members of the currency union. Prosperous members would attract factors of production from depressed regions, curing both inflation and unemployment.
The focus lies on maintaining external balance and internal balance after an asymmetric shock.
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DEEPENING ECONOMIC INTEGRATION: GERMAN MODEL
“Länderfinanzausgleich” (LFA), transfers funds from surplus states to deficit states. Poor states (Saarland or Bremen) benefit from richer states (Hessia or Bavaria).
Key: that no-one questions the political idea behind the notion that standards of living should be harmonized among federal states. It seems to make sense to citizens in Germany that small peripheral states cannot be expected to be economically as successful as large buzzing hubs in the centre of Germany.
Furthermore, fiscal policy, in other words: tax rates are harmonised within all Federal States as well as institutional features such as the pension age and pension payments.
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DEEPENING ECONOMIC INTEGRATION: GERMAN MODEL
Germany uses tax revenues per inhabitant to trigger transfers between federal states.
The idea is to bring the federal states tax revenue per inhabitant to 99.5% of the national average. The main feature hereby works via VAT collection. 25% of VAT receipts are pooled. If this does not suffice, the Federal Government makes up the difference. If one federal state has extreme budgetary difficulties, additional help is provided for the loss of sovereignty of its budget.
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DEEPENING ECONOMIC INTEGRATION: GERMAN MODEL
These simple rules could be applied to the Euro Zone in order to move the Euro economy towards an optimal currency union.
Average tax rate 2008 in the Euro zone stood at EUR7.180. Seven countries fall below this average (Cyprus, Spain, Greece, Slovenia, Malta, Portugal and Slovakia) and thus should receive transfers from the eleven countries above this threshold.
Note, that around Eur200bn of transfers would suffice to harmonize economic divergences across the euro zone.
Crucial to this analysis is of course, that currently tax rates are not harmonised as well as completely different tax bases exist, which is seen as one of the major ills of Greece.
Around 2% of euro zone GDP in transfers suffice to avoid crisis as we experience at the moment.
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DEEPENING ECONOMIC INTEGRATION: GERMAN MODEL dĂdžƌĞǀĞŶƵĞƐƉĞƌ ŝŶŚĂďŝƚĂŶƚ; hZͿ
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ϭϲ
dƌĂŶƐĨĞƌƐƌĞƋƵŝƌĞĚƉĞƌ ŝŶŚĂďŝƚĂŶƚ; hZͿ
ϵ͘ϱϵϬ ϳ͘Ϯϳϱ ϵ͘ϳϮϱ ϰ͘Ϯϳϱ ϱ͘Ϭϰϰ ϴ͘Ϭϴϳ ϳ͘ϲϰϱ ϲ͘ϴϬϰ ϮϬ͘ϰϭϴ ϯ͘ϴϱϱ ϴ͘ϳϮϭ ϵ͘ϱϯϲ ϯ͘ϴϰϯ ϰ͘ϮϮϮ Ϯ͘Ϭϭϳ ϭϬ͘ϳϬϲ ϳ͘ϭϴϬ
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dŽƚĂůƚƌĂŶƐĨĞƌƐƌĞƋƵŝƌĞĚ ; hZͿ
ĂƐйŽĨ'WϮϬϬϵ
ͲϮϱ͘ϳϬϱ͘ϵϰϴ͘ϵϳϮ Ͳϳ͘ϴϬϭ͘ϮϬϰ͘ϯϴϰ Ͳϭϭ͘Ϯϰϴ͘ϭϭϱ͘ϭϭϮ ϯϮ͘ϱϴϬ͘ϵϮϬ͘ϴϬϬ ϵϲ͘ϳϯϬ͘ϱϲϮ͘ϳϵϲ Ͳϱϳ͘ϴϭϲ͘ϰϭϭ͘ϯϮϴ ͲϮϳ͘ϳϭϱ͘ϮϲϮ͘ϯϮϴ Ϯϵϴ͘ϴϲϰ͘ϵϱϮ Ͳϲ͘ϰϬϰ͘ϰϴϲ͘ϯϰϰ ϭ͘ϯϲϱ͘Ϯϵϰ͘ϮϳϮ ͲϮϱ͘Ϯϳϳ͘Ϭϱϳ͘ϳϴϰ Ͳϭϵ͘ϲϮϴ͘ϵϱϲ͘ϱϳϮ ϯϱ͘ϰϯϮ͘ϮϬϱ͘ϯϭϮ ϱ͘ϵϵϮ͘ϴϱϱ͘ϯϬϴ Ϯϳ͘ϴϴϲ͘Ϭϭϭ͘ϭϮϬ Ͳϭϴ͘ϲϴϴ͘ϵϮϲ͘ϵϰϬ
ϮϬϬ͘Ϯϴϲ͘ϳϭϰ͘ϱϲϬ
Table 1: Tax revenues and transfers required. Sources: Eurostat, own calculation
Ͳϳ͕ϲй ͲϬ͕ϯй Ͳϲ͕ϵй ϭϯ͕ϳй ϵ͕Ϯй Ͳϯ͕Ϭй Ͳϭ͕ϴй ϭ͕ϴй Ͳϭϳ͕Ϭй Ϯϯ͕ϵй Ͳϰ͕ϰй Ͳϳ͕ϭй Ϯϭ͕ϲй ϭϳ͕Ϯй ϰϰ͕Ϭй ͲϭϬ͕ϵй
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KEYNES CURRENT ACCOUNT MEASURE
Alternative: Focus on current account of euro zone members.
Some countries tend to run current account deficits year after year, while some run current account surpluses year after year. Both is problematic.
Keynes of course saw this problem vey clearly. One of his institutional ideas for the IMF had been to establish a mechanism which would punish countries that run deficits or surpluses over the medium term.
The idea was to produce a current account that was close to zero and to encourage –or even require – countries to adopt a policy accordingly.
Eurozone as such has no current account surplus or deficit. This implies, that it produces savings sufficient for its required financing needs.
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KEYNES CURRENT ACCOUNT MEASURE
Thus, countries in the euro zone, that refuse to balance their current account, would be required to do so under penalty.
The easiest penalty is to tax governments of surplus countries, as the increased government deficit will reduce the current account surplus. This could then be transferred to deficit countries to decrease their government deficits.
This would be an organized wealth transfer, which need to be compared with an un-organised wealth transfer such as a default of a current account deficit country.
The key will be to harmonise the fiscal system among the member countries in such a way so as to avoid free riders or to foster animosity among countries. For example, different retirement ages in deficit and surplus countries would not be acceptable and viable. 9
KEYNES CURRENT ACCOUNT MEASURE ƵƌƌĞŶƚ ĂĐĐŽƵŶƚ ďĂůĂŶĐĞй'W ϮϬϭϬ ĞůŐŝƵŵ ͲϬ͕ϭ 'ĞƌŵĂŶLJ ϱ͕ϯ /ƌĞůĂŶĚ Ϭ͕ϯ 'ƌĞĞĐĞ Ͳϳ ^ƉĂŝŶ Ͳϯ͕ϵ &ƌĂŶĐĞ ͲϮ͕ϭ /ƚĂůLJ ͲϮ͕ϲ EĞƚŚĞƌůĂŶĚƐ ϱ͕ϱ ƵƐƚƌŝĂ ϭ͕ϲ WŽƌƚƵŐĂů Ͳϴ͕ϲ ^ůŽǀĞŶŝĂ ͲϮ͕ϰ ^ůŽǀĂŬŝĂ Ͳϰ͕ϯ &ŝŶůĂŶĚ Ϯ͕Ϯ ƵƌŽĂƌĞĂ Ϭ
Table 2: Current account balance % GDP April 2009- April 2010. Source: The Economist, May 2010
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EUROZONE BREAK-UP:
EXIT OF
DELINQUENT
Option 1: The liabilities of the balance sheets are not changed into the new currency so that the debt remains denominated in euro. Thus, the real value of the debt rises sharply, exacerbating the debt problem. In the case of Greece, at an assumed depreciation of 40% for example, the (euro) government debt in terms of (New Currency -) GDP would be at 200% (currently 120%).
Option 2: The liabilities of the balance sheets are exchanged into the new currency, the debt might be serviced, but in an inferior currency. This variant is ultimately a restructuring / or default. The consequence would no access to international capital markets. As deposits are exchanged into the new currency, it leads to a massive loss of wealth of households. The loss of wealth would also occur in the countries that hold Greek debt, i.e. the current account surplus countries of the euro zone.
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EUROZONE BREAK-UP:
EXIT OF
DELINQUENT
Expect a massive capital flight by residents (in expectation of option 2 and the default of banks).
An exit from the euro zone is institutionally not provided. Given the ratification of the Lisbon treaty, it's possible to lay down membership of the EU. Therefore, exiting the EU will imply exiting the formal euro membership.
This also implies that Greece could not access the EU transfers once outside the union (which currently amount to about 2-3 billion EUR per year). The free access to the European single market would be called into question as well.
The consequences of a Greek withdrawal from the euro zone will be especially felt within the euro zone. It would lead to stress on banks, insurance companies, pension funds, central banks and private households. It is not therefore in the interest of the other euro countries, that Greece or any other of the weak candidates are excluded from the euro zone.
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EUROZONE BREAK-UP:
EXIT OF
DELINQUENT LJ&ƌĂŶĐĞ LJƚŚĞĞƵƌŽ ĂŶĚ 'ĞƌŵĂŶLJ njŽŶĞ ƵƐƚƌŝĂ ϲϵй ϰϬй ĞůŐŝƵŵ ϲϳй ϯϭй LJƉƌƵƐ ϳϯй ϭϵй &ŝŶůĂŶĚ ϱϭй Ϯϴй &ƌĂŶĐĞ ϱϱй ϭϭй 'ĞƌŵĂŶLJ ϱϮй ϭϱй 'ƌĞĞĐĞ ϴϱй ϯϵй /ƌĞůĂŶĚ ϱϰй ϯϬй /ƚĂůLJ ϳϵй ϯϲй >ƵdžĞŵďŽƵƌŐ ϯϵй ϭϴй DĂůƚĂ ϱϱй ϭϵй EĞƚŚĞƌůĂŶĚƐ ϲϯй ϯϭй WŽƌƚƵŐĂů ϴϮй ϰϲй ^ůŽǀĂŬZĞƉƵďůŝĐ ϳϲй ϯϵй ^ůŽǀĞŶŝĂ ϴϱй ϯϲй ^ƉĂŝŶ ϳϲй ϰϰй
Table 3: Holding of external debt (as % of total, Natixis approximation) 13 Source: IMF, Natixis
EUROZONE BREAK-UP: GERMANY
EXIT OF
If the weaker members of the euro zone will not abandon it, the only thing Germany could consider, if it wants to avoid transferring money to deficit countries or if it wants to avoid the consequences for the Euro, would be to leave the euro zone itself.
Currently, leaving the euro zone implies leaving the EU. This would certainly be the end of the EU, so that we can assume that Germany will be encouraged to remain member of the EU, being allowed to introduce a new kind of Deutsche Mark (DM).
It should be noted that public opinion as well as populist political tendencies are shifting towards such a scenario.
What would be the consequences for the German economy? Similar questions will turn up as discussed above in the Greek example.
The question is how balance sheets are exchanged.
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EUROZONE BREAK-UP: GERMANY
EXIT OF
If liabilities are transferred 1:1 from Euro into DM, insurance companies, banks, pension funds will be bankrupt over night, as the asset side will devalue in DM terms, as the Euro depreciates to the DM.
Note from table 3 that Germany is sitting on a lot of euro zone assets that will continue to be denominated in euro. Furthermore, exchanging 1:1 into DM will lead to legal disputes, as debtors will not accept a shift to DM liabilities, as euro as a currency still exist.
Thus, as contracts are written in euro, we can assume that debt, pension and life insurance liabilities will remain to be honoured in euro or the equivalent DM amount.
That would lead to a massive loss in wealth for the German population. Given that the new DM will appreciate in value of about 30-40% compared to the Euro, German industry, which is mainly export oriented, will suffer as well enormously.
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EUROZONE BREAK-UP: GERMANY
EXIT OF
A further problem might hit the German corporate sector: foreign subsidiaries that have to be accounted for in DM on the balance sheet will lead to significant losses in value. To avoid this, companies will be encouraged to change head quarters into the euro zone in order to account in Euro and to shift production out of Germany. Overall, these effects will be detrimental to the German economy.
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CONCLUSION
We have discussed several possibilities of how the current sovereign debt crisis can be solved. At the end of the day, whatever solution will be forthcoming, it will lead to a transfer of wealth out of current account surplus countries, mainly Germany, to current account deficit countries, such as Greece and Portugal.
The reason is simply that one man’s wealth is another man’s indebtedness. We sit in one boat, especially in the already fairly integrated euro zone.
The only way to benefit long term is to integrate further, as surplus countries can then shape and influence common fiscal policies and the transfer of wealth will be in an orderly fashion.
Whether emotions and a lack of understanding of the balance of payments will allow for such integration will remain to be seen. 17
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