ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

The euro crisis: ways out for the euro zone and its member states

Vesa Vihriälä

28 November 2012

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Contents

• Where do we stand?

• Why is the euro crisis so stubborn?

• Way(s) out

• Three crises: a comparison

The phases of the crisis and policy reactions

2007Sub-primecrisis

2008Systemiccrisis

2009Greatrecession

2010Sovereigndebt crisis

2011Euro areaconfidence…

2012

…crisis

2013 ???

Policycoordination

Financialmarkets

Financialassistance

Bank support

Fiscal policy

Monetary policy

Liquidityprovision

Consolidation, structural reformsStimulus

Bilateral Greek loansEFSM, EFSF

SMP LTRO OMT

ESM

Regulatory andsupervision reforms

European semester, Six-pack, Two-pack, Fiscal compact

Banking union?

Recapitalization and guarantee schemes

Cutting policy rates

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Where do we stand now?

• Eurozone is in a double dip recession• Increasing divergence among the MS• Adjustment has started but mostly slow• Also growth potential has been affected

• ECB’s OMT promise has eased pressures

• But the short-term outlook remains weak, and the crisis still unresolved

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Great divergence in the euro zone

GDP at 2005 market prices Unemployment rate, %

Source: EU Commission projection, autumn 2012

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Great divergence: Baltic recovery vs. Greek stagnation (at best)GDP at 2005 market prices Unemployment rate, %

Source: EU Commission projection, autumn 2012

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Competitiveness has started to improve

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Strong variations of competitiveness in the Baltics

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Current accounts adjust, but slowly

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Significant fiscal consolidation

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

…which shows up in a gradual reduction of the headline deficits

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

…, including in the Baltics

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Why is the crisis so stubborn?

• The recessions associated with a financial crisis always deep and protracted

• Eurozone suffers from a coordination failure– No automatic stabilisation across MS– No automatic backing of sovereign debt by the

central bank– A vicious circle between banking problems and

sovereign debt problems at the MS level– Decision making on financial assistance difficult

among 17 sovereign nations

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Debt levels high, but not exceptional in the euro area on average

Sources: Bank of Finland, EKP, Eurostat, OECD, FED, BEA.

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Non-solutions

• Massive fiscal easing across the board– Several MS have too tight borrowing constraints

• Transforming the euro zone into a genuine federal construct– Not enough political cohesion; would require a Treaty

change, which time consuming and uncertain

• Dissolution of the euro zone– Potentially catastrophic macroeconomic

consequences, would wreck the European project

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Way(s) out• Strengthening the current policies

– Bigger, more flexible ESM

– Expanded ECB action (OMT; QE)

– Ambitious reforms and fiscal consolidation in the problem countries, slowing down consolidation in fiscally stronger MS

– Most realistic

• A banking union– Euro level supervision

– Euro level deposit insurance and resolution mechanism

– Very likely too slow to impact on the current crisis

• A broader fiscal union, yet short of a federal state– Eurobonds, significant euro area budget

– More centralised fiscal policy making

– Not likely (a last resort response if dissolution threat imminent)

• Debt restructurings: Greece for sure, others = ?

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Light at the end of the tunnel?

• In the best case financial conditions could improve by early 2013, following by a gradual real recovery starting by mid-2013

• Even then, growth will be slow and uneven across MS

• Experience => major set backs cannot be excluded

• But: EU has proved to be rather resilient in crises

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

A comparison of three crises

• Finland 91-94

• Greece 2009 -

• Latvia 2008 -

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Finland in the early 1990s

• Credit boom/bust as in Spain and Ireland• Key policy measures

– Improved price competitiveness through depreciation and wage moderation

– Relatively strong fiscal consolidation, despite a low debt level– Growth-enhancing tax reform– Strong restructuring of the banking sector– Emphasis on education and R&D; Nokia– EU membership

• Relatively rapid recovery (GDP), improvement of public finances, slow but steady improvement of employment

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Greece

• Significant convergence towards EA average based on domestic demand

• Badly-run public sector, high public debt• Small export sector, weak competitiveness• Adjustment has centred on fiscal consolidation, which

largely self-defeating given the high debt level and slow adjustment of competitiveness

• Difficult to see a sustained recovery without a further debt restructuring (PSI and OSI)

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Latvia

• A strong credit-financed domestic demand boom prior to the global crisis; a very high CA deficit

• Strong fiscal consolidation and low debt level helped in regaining market confidence in the exchange rate and public finances

• Wage flexibility improved competitiveness quite fast despite the exchange rate regime

• Political resistance to adjustment policies moderate compared to Greece, despite (because of?) substantially lower GDP/capita level

• GDP, CA recovery rapid

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

GDP adjustment fastest in Latvia

GDP index: Finland (1990/Q1=100), Greece (2008/Q1=100), Latvia (2008/Q1=100)

2006Q1 07Q1 08Q1 09Q1 10Q1 11Q1 12Q1Finland:

Greece, Latvia:1998Q1 89Q1 90Q1 91Q1 92Q1 93Q1 94Q1 95Q1 96Q1

Source: Eurostat.

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

2006Q1 07Q1 08Q1 09Q1 10Q1 11Q1 12Q1Finland:

Greece, Latvia:1998Q1 89Q1 90Q1 91Q1 92Q1 93Q1 94Q1 95Q1 96Q1

Also the UNR adjustment fastest in Latvia

Unemployment rate, %: Finland, Greece, Latvia

Source: Eurostat.

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

2006Q1 07Q1 08Q1 09Q1 10Q1 11Q1 12Q1Finland:

Greece, Latvia:1998Q1 89Q1 90Q1 91Q1 92Q1 93Q1 94Q1 95Q1 96Q1

Depreciation helpful for restoring competitiveness but not necessaryRelative unit labour costs (total economy), indexFinland (1990/Q1=100), Greece (2008/Q1=100), Latvia (2008/Q1=100)

Source: Eurostat.

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

2006Q1 07Q1 08Q1 09Q1 10Q1 11Q1 12Q1Finland:

Greece, Latvia:1998Q1 89Q1 90Q1 91Q1 92Q1 93Q1 94Q1 95Q1 96Q1

CA improves slowly, except in Latvia

Current account, % of GDP: Finland, Greece, Latvia

Source: Eurostat.

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Source: Eurostat. * = EU Commission forecast.2006 07 08 09 10 11 12*

Finland:Greece, Latvia:

1988 89 90 91 92 93 94 95 9613* 14*

Finland slowest to reduce public deficit, thanks to the low level of debt at the outset

General government deficit, % of GDP: Finland, Greece, Latvia

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

2006 07 08 09 10 11 12*Finland:

Greece, Latvia:1988 89 90 91 92 93 94 95 96

13* 14*Source: Eurostat. * = EU Commission forecast.

Debt dynamics works against Greece

General government debt, % of GDP: Finland, Greece, Latvia

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

07 08 09 10 11 12*2006Finland:

Greece, Latvia:1988 90 91 92 93 94 95 96

13* 14*89

Source: Eurostat. * = EU Commission forecast.

Greece relatively rich at start of the crisis

GDP per capita, PPP (constant 2005 international USD)Finland, Greece, Latvia

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Some lessons• Low public debt an essential cushion to limit market

reactions to deficits and to allow time for policies to work • Significant adjustment of competitiveness possible even

without exchange rate changes, but requires very flexible labour markets and social acceptance of harsh policies

• Sustained recovery requires also healthy real competitiveness; while the benefits of policies to this effect take time to materialize, also positive confidence effects possible => important not to delay action.

• A diversified supply of financial services probably better than relying purely on domestic institutions or purely on foreign institutions.

ELINKEINOELÄMÄN TUTKIMUSLAITOS, ETLATHE RESEARCH INSTITUTE OF THE FINNISH ECONOMY

Thank you!