What Have we Learnt about Monetary Integration

What Have we Learnt about Monetary Integration

What Have we Learnt about Monetary Integration. Prof. Carlos San Juan Mesonada Readings: 1) PAUL DE GRAUWE, 2006 What Have we Learnt about Monetary Integration since the Maastricht Treaty? JCMS 2006 Volume 44. Number 4. pp. 71130 2) PAUL DE GRAUWE AND YUEMEI JI, Social Europe Journal 25/02/2013 Panic-driven Austerity In The Eurozone And Its Implications Monetary policy in the EMU The Commissions view EMU, European Monetary Union (1999) Fix exchange rate ECB, European Central Bank

Single monetary policy The euro is the single currency shared by 19 of the 26 MS, Member States The euro is not the currency of all EU Member States. Two countries (Denmark and the United Kingdom) have opt-out clauses in the Treaty exempting them from participation, while the remainder (several of the more recently acceded EU members plus Sweden) have yet to meet the conditions for adopting the single currency. Andorra, Monaco, San Marino and the Vatican City have adopted the euro as their national currency by virtue of specific monetary agreements with the EU, and may issue their own euro coins within certain limits. However, as they are not EU Member States, they are not part of the euro area. See: http://ec.europa.eu/economy_finance/euro/index_en.htm Fiscal and structural policies remain in the hands of individual national authorities.

However, they must coordinate these policies in order to attain the common objectives of stability, growth and employment. A major coordination structure is the Stability and Growth pact, which contains agreed rules on fiscal discipline. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 2 What started as a banking crisis became a sovereign debt crisis/1 i. ii. iii. iv. i. ii. v.

Europes debt crisis was initially triggered by events in the American banking sector. Deregulation in the US financial sector, main cause. When a slowdown in the US economy caused over-extended American homeowners to default on their mortgages, banks all over the world with investments linked to those mortgages started losing money. Americas fourth largest investment bank, Lehman Brothers, collapsed under the weight of its bad investments, scaring other banks and investors with which it did business. The fear that more banks could fail caused investors and banks to take extreme precautions. Banks stopped lending to each other, pushing those reliant on such loans close to the edge. European banks that had invested heavily in the American mortgage market were hit hard. Carlos San Juan Mesonada. Universidad Carlos III de Madrid

3 What started as a banking crisis became a sovereign debt crisis/2 I. In an attempt to stop some banks from failing, governments came to the rescue in many EU countries like Germany, France, the UK, Ireland, Denmark, the Netherlands and Belgium. Also in Spain, Italy and Portugal. But the cost of bailing out the banks proved very high. II. i. III. In Ireland, it almost bankrupted the government until fellow EU countries

stepped in with financial assistance. As Europe slipped into recession in 2009, a problem that started in the banks began to affect governments more and more, as markets worried that some countries could not afford to rescue banks in trouble. i. ii. iii. IV. Investors began to look more closely at the finances of governments. Greece came under particular scrutiny because its economy was in very bad shape and successive governments had racked up debts nearly twice the size of the economy. Other MS suffer contagion and become suspicious: Ireland, Spain, Italy and Portugal The threat of bank failures meant that the health of government finances

became more important than ever. I. Governments that had grown accustomed to borrowing large amounts each year to finance their budgets and that had accumulated massive debts in the process, suddenly found markets less willing to keep lending to them. Source: EU Commission, 2015 See: Panic driven austerity for a critical view of the Council response to the debt crisis in 2010. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 4 Governance in the EMU/1 What started as a banking crisis became a sovereign debt crisis. Stability and Growth Pact show several shortcoming.

The debate about the governance in the EMU was re-open in the academic and political field Which theory better explain the real world? Carlos San Juan Mesonada. Universidad Carlos III de Madrid 5 Governance of the EMU/2. Introducing, the Degrauwe point of view The present governance of the euro area has been devised assuming that the world fits the monetarist-real-business-cycle theory. But that theory is not a correct representation of the world. The European monetary union is a remarkable achievement, but remains fragile because of the

absence of a sufficient degree of political union What have we learnt since the Treaty was signed? Carlos San Juan Mesonada. Universidad Carlos III de Madrid 6 I. Mundell I and Mundell II At the time of the signing of the Maastricht Treaty, the economic profession was still struggling with the pros and cons of monetary union. Delors report: provided the intellectual basis of the Maastricht Treaty (1991). At the time there were really two theories competing for academic attention, with very different policy implications. Mundell I (OCAs) provided the basis for widespread skepticism about the desirability of a monetary union in Europe

while Mundell II was used by the proponents of monetary union (The Delors report). Carlos San Juan Mesonada. Universidad Carlos III de Madrid 7 Optimal currency areas (OCA) The OCA theory determines the conditions that countries should satisfy to make a monetary union attractive, i.e. to ensure that the benefits of the monetary union exceed its costs. The conditions that are needed to make a monetary union among candidate Member States attractive can be summarized by three concepts: Symmetry (of shocks)

Flexibility Integration Carlos San Juan Mesonada. Universidad Carlos III de Madrid 8 Symmetry and flexibility in OCAs Figure 1 presents the minimal combinations of symmetry and flexibility that are needed to form an optimal currency area by the downward-sloping OCA line. To the right of the OCA line the degree of flexibility is sufficiently large given the degree of symmetry to ensure that the benefits of the union exceed the costs.

Points on the OCA line define combinations of symmetry and flexibility for which the costs and the benefits of a monetary union just balance. It is negatively sloped because a declining degree of symmetry (which raises the costs) necessitates an increasing flexibility. To the left of the OCA line there is insufficient flexibility for any given level9 of symmetry. Symmetry and integration in OCAs Figure 2 presents the minimal combinations of symmetry and integration that are needed to form an optimal currency area, OCA. Points to the right of the OCA line represent groupings of countries for which the benefits of a monetary union exceed its costs.

The OCA line represents the combinations of symmetry and integration among groups of countries for which the cost and benefits of a monetary union just balance. It is downward sloping for the following reason: A decline in symmetry raises the costs of a monetary union. These costs are mainly macroeconomic in nature. MS benefit from the efficiency gains of a monetary union. Thus, the additional (macroeconomic) costs produced by less symmetry can be compensated by the additional (microeconomic) benefits produced by more integration. 10

Mundell II (1973) The new Mundell (Mundell II) starts from the situation of a world of free mobility of capital; In a world of free mobility of capital, the exchange rate ceases to be a stabilizing force. Instead, according to Mundell II, the exchange rate becomes a target of destabilizing speculative movements and thus a source of large asymmetric shocks. Thus, the view of Mundell I implying that the exchange rate could be used to stabilize the economy after an asymmetric shock should be abandoned. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 11 Mundell II (1973)/2 In the world of Mundell II joining a monetary union should not be

seen as a cost arising from the loss of the exchange rate as an adjustment mechanism, but as a benefit of eliminating a source of asymmetric shocks. For most countries, the exchange rate does not provide a degree of freedom but uses up a degree of freedom in their economic policy since they have to stabilize this asset price. Mundell II is based on the idea that foreign exchange markets are not efficient and should not be trusted to guide countries towards macroeconomic equilibrium This view has received increased empirical backing. exchange rate is disconnected most of the time from its fundamental value (see De Grauwe and Grimaldi, 2006, for evidence and implications of these findings). Carlos San Juan Mesonada. Universidad Carlos III de Madrid 12

Mundell II became a major promoter of monetary union/3 There is a second insight in Mundell II: 1. Only in a monetary union can capital markets be fully integrated so that they can be used as an insurance mechanism against asymmetric shocks (see Asdrubali et al., 1996). 2. When countries remain outside a monetary union they cannot hope to profit from insurance against asymmetric shocks provided by capital markets in the rest of the world. 1. 2. 3. The reason is that the large and variable exchange risk premia prevent these capital markets from providing insurance against asymmetric shocks.

Thus the world of Mundell II is one in which countries that stay outside a monetary union will have to deal with large asymmetric shocks that arise from the instability of international capital flows. These countries ability to insure against traditional asymmetric shocks is severely restricted when they stay outside a monetary union. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 13 Maastricht Treaty & academic economists minds Mundell II/4 At the time the Maastricht Treaty was signed, most academic economists

minds were framed by Mundell I and scepticism about the prospects of a monetary union was widespread. In the end Mundell II prevailed. Why did this happen? There was first the collapse of the EMS in 199293. This historical episode made clear that in a world of free mobility of capital, fixed exchange rates were unsustainable as long as central banks maintained their own independent monetary policies. The EMS-crisis convinced many continental European economists that a choice had to be made for one of the two corner solutions in exchange rate regimes, i.e. full flexibility of exchange rates or monetary union. Many decided that the latter would be the least bad choice. Mundell II triumphed on the European continent. But still no so popular in the US academic minds in 1999 Carlos San Juan Mesonada. Universidad Carlos III de Madrid 14

Mandell II and Monetarism/5 Monetarism, instead, stressed that activist monetary policies become sources of instability and that central banks should focus on their core business which is to maintain price stability. The logical consequence of monetarism was the view that central banks do not lose their capacity to stabilize their national economies when entering a monetary union, since they did not have such a capacity in the first place. In this monetarist vision (and Mundell II was also an outgrowth of monetarism) the costs of a monetary union are small. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 15

Mandell II and Monetarism/5 costs of a monetary union are small In terms of our Figures 1 and 2, the OCA line is located very close to the origin. The OCA-region is a vastly expanded one. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 16 Mundell II, asymmetric shocks A number of countries in EMU have recently experienced large losses of competitiveness: an asymmetric shock The Great Recession of 2008 was an asymmetric shock This phenomenon will lead to the need to adjust in many countries.2 In particular, the countries that have lost competitiveness will have to restore it. In a monetary union this can only come about by having lower

rates of price and wage inflation than the average of the euro area. However, since the ECB is targeting a rate of inflation below 2 per cent, the countries that have lost competitiveness will find it very difficult to lower their inflation rates below the euro area average without introducing outright deflation, and large increases in unemployment. [like in Spain after 2010] Carlos San Juan Mesonada. Universidad Carlos III de Madrid 17 Real Effective Exchange rate Figure 3: The striking fact is the extent to which yearly inflation differentials have led to sustained changes in these real exchange

rates. As a result of these trends, some countries (Portugal, Netherlands, Spain and Italy) have lost a significant amount of price competitiveness. Others, like Germany and Austria have gained a significant amount of price competitiveness. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 18 Inflation Gap

Source: BdE, 2013 It can be argued (Degrauwe, 2006) that, by making it more difficult for countries to restore their lost competitiveness, the low inflation target of the ECB introduces a powerful rigidity in the euro area. Thus paradoxically a higher inflation target would introduce more flexibility. It would also lead to less tension within the euro area. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 19 Deficit expansion in Spain after the great recession of Sept.-08 Source : FUNCAS, SEFO, N 5 2013 Carlos San Juan Mesonada. Universidad Carlos III de Madrid

20 Assessing the sign of budgetary policy and fiscal consolidation in Spain (Austerity policy means -1.7 pp of GDP in 2012 excluding support to financial institutions) Source : FUNCAS, SEFO, N 5 2013 Carlos San Juan Mesonada. Universidad Carlos III de Madrid 21 II. Endogeneity of the OCA Criteria Frankel and Rose (1998) came up with the idea that the OCA criteria are endogenous. By that they meant that these criteria are affected by the very decision to start a monetary union.

Thus countries that before the start of the union fail to satisfy the OCA criteria may, by the very fact that they form a monetary union, change economic conditions in such a way that these conditions get satisfied. As a result the decision to start a monetary union has a self-fulfilling property. By starting the monetary union the conditions that are favourable for a monetary union get satisfied, making the decision to form a monetary union the right one. Conversely, a decision not to start a union when the conditions are not satisfied helps to maintain unfavorable conditions so that the negative decision also appears to have been the right one.

Carlos San Juan Mesonada. Universidad Carlos III de Madrid 22 II. Endogeneity of the OCA Criteria/2 There are different mechanisms that can make the OCA criteria endogenous. 1) First, monetary union can affect trade flows and intensify trade integration, thus increasing the benefits of the monetary union. 2) Second, monetary integration leads to more intense financial integration thereby facilitating the emergence of insurance mechanisms [e.g.: European Bank Authority, EBA]. a) The latter reduce the costs of asymmetric shocks. 3) Third, a monetary union affects the functioning of the labor markets and can potentially increase their flexibility, thereby

reducing the costs of adjusting to asymmetric shocks in the monetary union. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 23 II. Endogeneity of the OCA Criteria/3 We show the effects of these mechanisms in Figures 4 and 5 which are the same as Figures 1 and 2. We have now put the euro area to the left of the OCA line, taking the view that when the euro area was started its members were not yet ready to form a monetary union. The endogenous mechanisms have the effect of moving the euro area towards the OCA area in Figures 4 and 5. This happens because monetary union increases the degree of economic (trade) integration

(Figure 5). Carlos San Juan Mesonada. Universidad Carlos III de Madrid 24 Symetry & Flexibility: EMU Is safe to conclude that a monetary union has a significant positive effect on economic integration, thereby moving the euro area towards the OCA area. What about flexibility? If monetary union increases the pressure for labor markets to become more flexible The decision to enter a monetary union also improves the OCA criteria tending to shift the euro area upwards towards the OCA area.

It must be admitted that there is no consensus about this flexibility effect. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 25 UCL: Unit Labor Cost Breakdown, Spain UCL: Unit Labor Cost EMU Austerity policy Nominal UCL Productivity gain contributions GDP deflator

Carlos San Juan Mesonada. Universidad Carlos III de Madrid 26 Unit labor cost in Spain UCL: Unit Labor Cost NEER: Nominal Exachange Rate REER: Real Exachange Rate HICP: Harmonized Consumer Price Index Carlos San Juan Mesonada. Universidad Carlos III de Madrid

27 The effect of monetary union on symmetry Has been heavily debated among economists (see De Grauwe, 2005). No consensus seems to have emerged here, although the empirical work of Frankel and Rose (1998) indicating that trade integration and output correlation go hand-in-hand has become quite influential. On the whole the theory and the evidence seem to suggest that there is a dynamics of endogeneity that has the potential of moving the euro area countries towards the OCA area. How important this endogeneity effect

is, however, cannot be determined at this stage of our knowledge. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 28 III. The Governance of Monetary Union There is a fundamental difference between the monetary union among the US states and the European monetary union. The US federal government has a monopoly of the use of coercive power within the union and will surely prevent any state from seceding from the monetary union.

The contrast with the Member States of the euro area is a very strong one Carlos San Juan Mesonada. Universidad Carlos III de Madrid 29 Public Deficit in US versus EMU Carlos San Juan Mesonada. Universidad Carlos III de Madrid 30 Panic driven austerity One question then remain, why was a such severe austerity plan implemented if from the

early stage many economists did predict its negative GDP consequence and why did the BCE didnt take earlier measures? The financial market directly drove the intensity of each countrys austerity program. Paul de Grauwe & Yuemei Ji, Panic driven austerity in the eurozone and its implications, Social Europe, Colums&Interviews, (online), 25/02/2013, http://www.socialeurope.eu/2013/02/panicdriven-austerity-in-the-eurozone-and-its-implications/? utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+social-europe%2FwmyH+ %28Social+Europe+Journal%29 Carlos San Juan Mesonada. Universidad Carlos III de Madrid 31 Impact of austerity in GDP growth The negative impact of the consolidation measures

taken by the ECB on the GDP was confirmed by Holland and Portes (2012). They implemented policy plans based on fiscal impulse (tax based and spending based) and considered two alternatives scenarios, under the first assumptions the economy is behaving in normal times and under the second assumption they allowed liquidity constraints and an impaired interest rate channel to reflect the current conditions. The results were striking, see next graph with the simulations results on the debt to GDP ratio.... Carlos San Juan Mesonada. Universidad Carlos III de Madrid 32

Impact of fiscal consolidation on fiscal balance 2013 and on government debt to GDP ratio 2013 The results were striking, fiscal consolidation in Europe has increased rather than decreased the debt to GDP ratio, not only in countries with high debt and deficit but also in Germany and the U.K. See: Holland D. & Portes J. 2012, Self defeating austerity?, National Economic Institute Review, n222 October. 33 Austerity measure and spread 2011 (source: Financial Times) Indeed according to the Financial Time the higher the spread in 2011, the more intense were the austerity

measures. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 34 Eurozone policy seems driven by market sentiment. De Grauwe and JI, (2013) argues that fear and panic led to excessive, and possibly self-defeating, austerity in the south while failing to induce offsetting stimulus in the north. The resulting deflation bias produced the double-dip recession and perhaps more dire consequences. As it becomes obvious that austerity produces unnecessary suffering, millions may seek liberation from euro shackles. Southern Eurozone countries have been forced to

introduce severe austerity programs since 2011. Where did the forces that led these countries into austerity come from? Are these forces the result of deteriorating economic fundamentals that made austerity inevitable? Or could it be that the austerity dynamics were forced by fear and panic that erupted in the financial markets and then gripped policymakers. Furthermore, what are the implications of these severe austerity programs for the countries involved? What should we think of these two strongly opposing views? BrusselsFrankfurt consensus/1 The BrusselsFrankfurt consensus is based on two academic theories:

1. 2. monetarist theory real business cycle theory If it tries too hard to fine-tune the economy it will end up with more inflation. Thus the best thing a central bank can do is to stabilize the price level. [inflation target] This will have the incidental effect of producing the best possible outcome in terms of stability of the economic cycle. [but the main target is long term stability] 1. The monetarist theory, in which the central bank cannot do much to stabilize the economy.

Carlos San Juan Mesonada. Universidad Carlos III de Madrid 37 The real business cycle theory BrusselsFrankfurt consensus/2 the sources of economic cycles are: shocks in technology (supply-side shocks) and changes in preferences (unemployment being mainly the result of workers taking more leisure). There is very little the central bank can do about these movements. The best is to keep the price level on a steady course. This will minimize the effects of these shocks.

In addition, a macroeconomic policy based on the objective of price stability is the best thing the central bank can do to promote growth. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 38 The real business cycle theory BrusselsFrankfurt consensus/3 Lucas: the central banks contribution to economic growth by maintaining price stability is immensely more important than an ephemeral success in reducing business cycle movements. That was the background to solve the crisis in 2010: BCE cares about price stability and in so doing makes the best possible contribution to maintaining

macroeconomic stability and to fostering economic growth; and national governments that keep budgetary discipline and do their utmost to introduce market flexibility. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 39 The real business cycle theory BrusselsFrankfurt consensus/4 In such a world the productivity driven shocks can best be dealt with by governments keeping budgets in balance. Furthermore, in such a world the need to have an active budgetary policy at the euro area

level does not exist. It will also come as no surprise to those who have studied economic history that these were also the views that prevailed prior to the Great Depression. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 40 The Brussels-Frankfurt Consensus Carlos San Juan Mesonada. Universidad Carlos III de Madrid 41 The alternative OCA/1 Deeply rooted in Keynesian and neo-Keynesian ideas:

shocks in the economy that do not originate in the supply side but find their origin in the demand side. Animal spirits, i.e. waves of optimism and pessimism capture consumers and investors. These waves have a strong element of self-fulfilling prophesy. When pessimism prevails, consumers and investors alike hold back their spending, thereby reducing output and income, and > validating their pessimism. when optimism prevails, consumers and investors will spend a lot, thereby increasing output and income, and > validating their optimism. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 42

The savings paradox. The alternative OCA/2 The corollary of this effect is the well-known savings paradox. When pessimism prevails and consumers attempt to save more, the ensuing decline in income will prevent them from increasing their savings ex post. These phenomena were analyzed by Keynes long ago, but have been thrown in the dustbins of economic history. Yet these ideas remain powerful, and have important influences on the governance of the monetary union. In the logic of these Keynesian ideas, a monetary union needs a central budgetary authority capable of offsetting the desire of consumers gripped by pessimism to increase their savings, by dissaving of the central government.

Carlos San Juan Mesonada. Universidad Carlos III de Madrid 43 The logic of these Keynesian ideas The alternative OCA/2 To the extent that there are asymmetric developments in demand at the national level, the existence of an automatic redistributive mechanism through a centralized budget can be a powerful stabilizing force The responsibility of a central bank extends beyond price stability even if this remains its primary objective of ECB. There are movements in demand that cannot be

stabilized by only caring about price stability. Quantitative easy Carlos San Juan Mesonada. Universidad Carlos III de Madrid 44 The monetarist-real-business-cycle (MRBC) theory policy implications From the preceding analysis it appears that the present governance of the euro area has been devised based on the assumption that the world is one which fits the monetarist-real-business-cycle (MRBC) theory. If the latter theory is indeed the correct view of the world, there is little need to move on with political integration in the euro area, and the present political governance of the euro area is perfectly adapted to the world in which we live.

But what if the MRBC theory is not a correct representation of the world? What if there are large movements in optimism and pessimism that affect consumers and investors behavior? If we live in a world where such large movements are possible, then the euro area may have the wrong institutional design. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 45 Central banks' securities purchase as % of GDP Source: Daniel Gros, Cinzia Alcidi and Alessandro Giovanni, Central banks in times of crisis : the FED vs the ECB , Economic policy, CEPS Policy Brief, (online), n276 11 July 2012, http://www.ceps.eu/book/central-banks-times-crisisfed-vs-ecb Carlos San Juan Mesonada. Universidad Carlos III de Madrid

46 Conclusions What have we learnt about monetary unions since the Treaty of Maastricht? A first idea which may have helped to convince the critics of monetary union is that, even if the euro area countries do not yet satisfy the OCA criteria, they will in the future as the monetary union sets in motion a process of more intense integration. This good-news-theory suggests that the euro area may be moving safely into the OCA area by the very fact that the euro area was started. The central idea here is that the absence of a political union is an important flaw in the governance of the euro

area. Carlos San Juan Mesonada. Universidad Carlos III de Madrid 47 Conclusions: ECB versus FED Council of the EU is putting all the burden of macroeconomic management in the euro area on the shoulders of the ECB [2001; 2010] The ECB alone cannot fulfill this role. This contrasts very much with the US where we have seen that both the central bank and the federal government have used their respective instruments to stabilize the business cycle. Carlos San Juan Mesonada. Universidad

Carlos III de Madrid 48 Conclusions The EU needs a budgetary integration The absence of a minimal degree of budgetary integration that can form the basis of an insurance mechanism is another flaw in the design of European monetary union. Such an insurance mechanism does not have to be as large and unconditional as those that exist within centralized countries. It is important, however, as a mechanism of solidarity even if its size is limited. It is difficult to conceive how a union can be politically sustainable if each time a country of the union gets into trouble because of asymmetric developments, it is told by the other members that it is entirely its own fault and that it should not count on any help. Such a union will not last (De Grauwe, 2006)

Carlos San Juan Mesonada. Universidad Carlos III de Madrid 49 Conclusions Quantitative easy Ben Bernake: 2008 plan to bay $5000 mill. Trash assets base on morgates. -2009: $300 mill. Adquisitions

of Iong term bonds Carlos San Juan Mesonada. Universidad Carlos III de Madrid 50 Conclusions: The BCE unconventional monetary policy: later an smaller According to Gagnon et al. (2011), the FED large-scale asset purchases of 2010 lead to a reduction of the ten-year term premium between 30 and 100 basis points. Moreover by improving market liquidity and removing asset with high prepayment risk from private portfolio, the FED had an even

stronger effect on the long-term interest rates on agency debt and agency back mortgage securities. The FED has therefore succeeded in stimulating the economic activity. Unfortunately the ECB policy was Carlos San Juan Mesonada. Universidad not as successful; Carlos III de Madrid 51 Conclusions: FED Interest rate fast reduction since the BCE is lagging behind Carlos San Juan Mesonada. Universidad Carlos III de Madrid

52 Conclusions: Positive effects in the spread of corporations after the 2008 crisis in the US Carlos San Juan Mesonada. Universidad Carlos III de Madrid 53 Exercise: Comment about Panic driven austerity De Grauwe and Ji, 2013 drawn three conclusions from their analysis: http://baobab.uc3m.es/monet/monnet/spip.php?article524 1. 2.

3. Since the start of the debt crisis financial markets have provided wrong signals; led by fear and panic, they pushed the spreads to artificially high levels and forced cash-strapped nations into intense austerity that produced great suffering. They also gave these wrong signals to the European authorities, in particular the European Commission that went on a crusade trying to enforce more austerity. Thus financial markets acquired great power in that they spread panic into the world of the European authorities that translated the market panic into enforcing excessive austerity. While the ECB finally acted in September 2012, it can also be argued that had it acted earlier much of the panic in the markets may not have occurred and the excessive austerity programs may have been avoided. Panic driven austerity: Panic and fear are not good guides for economic policies.

These sentiments have forced southern EZ countries into quick and intense austerity that not only led to deep recessions, but also up to now, did not help to restore sustainability of public finances. On the contrary, the same austerity measures led to dramatic increases of the debt-to-GDP ratios in southern countries, thereby weakening their capacity to service their debts. In order to avoid misunderstanding, we are not saying that southern European countries will not have to go through austerity so as to return to sustainable government finances.

They will have to do so. What we are claiming is that the timing and the intensity of the austerity programs have been dictated too much by market sentiments of fear and panic instead of being the outcome of rational decision-making processes. Panic driven austerity: Financial markets did not signal northern countries to stimulate their economies Financial markets did not signal northern countries to stimulate their economies, thus introducing a deflationary bias that lead to the doubledip recession. The desirable budgetary stance for the Eurozone as whole consists in the south pursuing austerity, albeit spread over a longer period of time, while the north engages in some fiscal stimulus so as to counter the deflationary forces originating from the south. The northern countries have the capacity to do so. Most of them have

now stabilised their debt-to-GDP ratios. As a result, they can allow a budget deficit and still keep their ratio constant. Germany in particular could have a budget deficit of close to 3%, which would keep its debt-to-GDP ratio constant. Given the size of Germany, this would allow for a significant stimulus for the Eurozone as a whole. Panic driven austerity: Financial markets did not signal northern countries to stimulate their economies/2 The intense austerity programs that have been dictated by financial markets create new risks for the Eurozone. While the ECB 2012 decision to be a lender of last resort in the government bond markets eliminated the existential fears about the future of the Eurozone, the new risks for the future of the Eurozone now have shifted into the social and political sphere. As it becomes obvious that the austerity programs produce unnecessary sufferings especially for the millions of people who have been thrown into unemployment and poverty,

resistance against these programs is likely to increase. A resistance that may lead millions of people to wish to be liberated from what they perceive to be shackles imposed by the euro. Source : FUNCAS, SEFO, N 5 2013 Carlos San Juan Mesonada. Universidad Carlos III de Madrid 58 Exercises: explain the following graphs Carlos San Juan Mesonada. Universidad Carlos III de Madrid 59 Credit Default Swaps (CDS) Spread

2012 Source: FUNCAS, SEFO, 5 Carlos San Juan Mesonada. Universidad Carlos III de Madrid 60 Public opinions and elections in UK Exercise: See the videos in CEP Elections economics in the UK and critically comment Carlos San Juan Mesonada. Universidad Carlos III de Madrid 61

CEP Elections economics in the UK Austerity & Productivity in UK elections videos: 1. Austerity | John Van Reenen https://www.youtube.com/watch?v=ifv51GKGxmM&index=2&list=PLyYjq-iDxl32KwFjBqAqXHHb0LXG9MhZ 2. Productivity & Business | Anna Valero: https://www.youtube.com/watch?v=Rn25PjLynDk&list=PLyYjq-iDxl32KwFjBqAqXHHb0LXG9MhZ&index=7 3. Britain & Europe | Thomas Sampson:

https://www.youtube.com/watch?v=BFQ_gJRcOfw&index=8&list=PLyYjq-iDxl32KwFjBqAqXHHb0LXG9MhZ Carlos San Juan Mesonada. Universidad Carlos III de Madrid 62 Public opinion Carlos San Juan Mesonada. Universidad Carlos III de Madrid 63

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