The Euro Crisis & Greece: The Euro Crisis & Greece: Six MistakesSix Mistakes

Jeffrey FrankelJeffrey FrankelHarpel ProfessorHarpel Professor

““Whither Europe? Lessons, Risks, and the Way Forward,”Whither Europe? Lessons, Risks, and the Way Forward,” lecture serieslecture series

Center for International Development, Center for International Development, Center for European Studies, and the Center for European Studies, and the

Kokkalis Program on Southeastern & East-Central EuropeKokkalis Program on Southeastern & East-Central Europe

Harvard University, Feb.13, 2012 Harvard University, Feb.13, 2012 

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6 mistakes made by euroland’s 6 mistakes made by euroland’s leaders regarding Greeceleaders regarding Greece

Slender rays of hope: Slender rays of hope: – The hour of the technocratsThe hour of the technocrats– Proposals for the futureProposals for the future

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5 mistakes made by euro leaders5 mistakes made by euro leaders

Admitting Greece to the € in the first place, Admitting Greece to the € in the first place, – a country that was not yet ready.a country that was not yet ready.

Pretending to enforce the fiscal criteria:Pretending to enforce the fiscal criteria:BD < 3% of GDP & Debt < 60% of GDP.BD < 3% of GDP & Debt < 60% of GDP.

Allowing Mediterranean countries’ bonds spreads near 0Allowing Mediterranean countries’ bonds spreads near 0– helped by investors’ under-perception of risk helped by investors’ under-perception of risk (2003-07)(2003-07)– and artificial high credit ratings. But alsoand artificial high credit ratings. But also– ECB acceptance of Greek bonds as collateralECB acceptance of Greek bonds as collateral. .

When the crisis hit, the leaders buried their heads in the sand:When the crisis hit, the leaders buried their heads in the sand:2 years ago, sending Greece to the IMF was “unthinkable.”2 years ago, sending Greece to the IMF was “unthinkable.”1 year ago, restructuring of the debt was “unthinkable.”1 year ago, restructuring of the debt was “unthinkable.”

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The Treaty of Maastricht The Treaty of Maastricht (1991) (1991) surprised many surprised many economists by emphasizing fiscal criteria economists by emphasizing fiscal criteria

as qualifications for membership.as qualifications for membership.

Why did the designers do it?Why did the designers do it?

TheoryTheory I: I: Jason Jason & the Golden Fleece& the Golden Fleece

TheoryTheory II: II: Theseus Theseus & the stone& the stone

TheoryTheory III: III: Odysseus Odysseus & the mast. & the mast.

Frankel, Economic Policy (London) 16, April 1993, 92-97.

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The motivation forThe motivation for thethe MaastrichtMaastricht fiscalfiscal criteriacriteria

was the same as for the No Bailout Clausewas the same as for the No Bailout Clauseand the Stability & Growth Pact (1997):and the Stability & Growth Pact (1997):

Skeptical German taxpayers believed that, Skeptical German taxpayers believed that, before the € was done, they would be asked to before the € was done, they would be asked to bail out profligate Mediterranean countries.bail out profligate Mediterranean countries.

European elites adopted the fiscal rules to European elites adopted the fiscal rules to demonstrate that these fears were groundless.demonstrate that these fears were groundless.

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After the euro came into existenceAfter the euro came into existence

it became clear the German taxpayers had been rightit became clear the German taxpayers had been right– and the European elites were wrong.and the European elites were wrong.

E.g., Greece persistently violated the 3% deficit rule.E.g., Greece persistently violated the 3% deficit rule.

The large countries violated the rule too.The large countries violated the rule too.

SGP targets were “met” by overly optimistic forecasts.SGP targets were “met” by overly optimistic forecasts.

SGP threats of penalty had zero credibility.SGP threats of penalty had zero credibility.

Yet each year the ostrich elites stuck Yet each year the ostrich elites stuck their heads deeper & deeper into the sands.their heads deeper & deeper into the sands.

The Greek budget deficitThe Greek budget deficitnevernever got below the 3% of GDP limit, got below the 3% of GDP limit,

nor did the debt ever decline toward the 60% limitnor did the debt ever decline toward the 60% limit

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Spreads for Italy, Greece, & other Mediterranean Spreads for Italy, Greece, & other Mediterranean members of members of €€ were near zero, from 2001 until 2008. were near zero, from 2001 until 2008.

Market Nighshift Nov. 16, 2011

When PASOK leader George When PASOK leader George Papandreou became PM in Oct. 2009,Papandreou became PM in Oct. 2009,

he announced he announced – that “foul play” had misstated the fiscal that “foul play” had misstated the fiscal

statistics under the previous government:statistics under the previous government:

– the 2009 budget deficit the 2009 budget deficit ≠≠ 3.7%, 3.7%, as previously claimed, as previously claimed, but > 12.7 % !but > 12.7 % !

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Missed opportunityMissed opportunity

The EMU elites had to know that someday The EMU elites had to know that someday a member country would face a debt crisis.a member country would face a debt crisis.

In early 2010 they should have viewed Greece as a In early 2010 they should have viewed Greece as a good opportunity good opportunity to set a precedent for moral hazard:to set a precedent for moral hazard:– The fault egregiously lay with Greece itself.The fault egregiously lay with Greece itself.

Unlike Ireland or Spain, which had done much right.Unlike Ireland or Spain, which had done much right.

– It is small enough that the damage from debt restructuring It is small enough that the damage from debt restructuring could have been contained at that time.could have been contained at that time.

Unlike Italy now, if the worst happens.Unlike Italy now, if the worst happens.

They should have applied the familiar IMF formula: They should have applied the familiar IMF formula: serious bailout, but only conditional on serious serious bailout, but only conditional on serious policypolicy reforms reforms && serious Private serious Private SectorSector Involvement.Involvement.

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But the ostriches But the ostriches stuck their heads stuck their heads ever further ever further down in the sand.down in the sand.

There is even less reason now to think There is even less reason now to think Brussels can impose fiscal constraints on Brussels can impose fiscal constraints on borrowers or ask unlimited transfers from borrowers or ask unlimited transfers from creditor country taxpayers than before.creditor country taxpayers than before.

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Slender rays of hope, #1Slender rays of hope, #1

Greece, IrelandGreece, Ireland & & Portugal did finally go toPortugal did finally go to the the IMF; IMF; Germany Germany && banks did finally agree to write down Greek debt. banks did finally agree to write down Greek debt. – But it has always been much too little, too late.But it has always been much too little, too late.

The only solution for the short-term: The only solution for the short-term: – a lot more money a lot more money

from ECB & from ECB & national governments, national governments,

– conditional on reforms + PSI, country-by-country.conditional on reforms + PSI, country-by-country.

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Slender rays of hope, #2: Slender rays of hope, #2: The Hour of the TechnocratsThe Hour of the Technocrats

A government of technocrats under Mario Monti A government of technocrats under Mario Monti in Italy is a huge improvement in Italy is a huge improvement over the disaster of Berlusconi. over the disaster of Berlusconi.

Similarly Lucas Papademos in GreeceSimilarly Lucas Papademos in Greece– But he has been given even less freedom of But he has been given even less freedom of

action than Monti: his term is very short action than Monti: his term is very short and he wasn’t allowed to pick his cabinet.and he wasn’t allowed to pick his cabinet.

Mario Draghi became President of the ECB, Nov.1, 2011

He was under intense pressure to expand his predecessor’s purchases of large quantities of periphery-country bonds.– The ECB was urged to be the “big bazooka”:

to play the role of “lender of last resort,” an abuse of that term, – which is supposed to refer to back-stopping banks, not countries.

– If the ECB interpreted its mandate literally, as no more than keeping inflation low, then the euro might break up.

On the other hand, as Draghi knew:– the ECB is legally prohibited from financing governments directly;– If he had quickly bailed out Italy & the others, he would have:

facilitated a continuation of Berlusconi-style irresponsibility;been immediately written off by Germans as another profligate Italian.

So far, Draghi’s LTRO (Longer-Term Refinancing Operation) has been a brilliant success.

On Dec. 22, he caught everyone by surprise by the clever ploy of doing exactly what he had previously announced he would do:– loans to banks for 3 years, at low interest.

High take-up: € 489 b, 523 banks – especially in troubled countries.– No stigma.

– Brought down interbank spreads & country spreads,while consistent with central bank LoLR mandate.

2nd round in late February may be twice as big.

Any solution to the euro crisis must include a way to prevent repeats in the long term.

As the Maastricht architects knew all along, this means a way of preventing fiscal moral hazard: – preventing individual countries from running big deficits &

debts, expecting to be bailed out in the event of a crisis.– The German taxpayers are no more

supportive of a “transfer union” than ever.

Merkel’s “fiscal compact” is the 6th mistake:– yet another declaration of determination

to strengthen the SGP,– incl., via budget limits in national laws/constitutions.– One SR problem: Europeans think austerity is expansionary

Perhaps the Fiscal Compact misunderstands the US system

Yes, despite a common currency, the 50 states do not seem to have moral hazard:– the federal government has never bailed one out,

and nobody expects it to now.– But that is not because of the budget rules

that (49 of) the states have.Their rules are voluntary, varied, and flexible.Some states do have debt troubles,

– and even default.

How the US avoids moral hazardin the 50 states

Government spending at the state level is a far smaller share of income than at the federal level, – let alone on the part of European states.– Is Europe ready for that? No.

When one state begins to run its debt too high, the private market automatically imposes an interest rate penalty.– E.g., California today.– Gives states the incentives to get back in line.– This mechanism was expected to operate in euroland

Alesina, et al Alesina, et al ((EPEP, 1992) and , 1992) and Goldstein Goldstein && Woglom Woglom (1992).(1992).

but conspicuously failed from the first day.– Which showed that moral hazard had not been addressed.

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EMU Ostrich

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References by the speakerReferences by the speaker

““The ECB’s Three Big Mistakes,” ,” VoxEU, May 16, 2011., May 16, 2011.  “Optimal Currency Areas & Governance", slides session on the session on the Challenge of Europe at the  at the Annual Conference of George Soros’ of George Soros’ INET, April 2011; , April 2011; video available, including my available, including my presentation. . ""Let Greece Go to the IMF," Jeff Frankel’s blog, Feb.11, 2010.," Jeff Frankel’s blog, Feb.11, 2010.Over-optimism in Forecasts by Official Budget Agencies and Its Implications," 2011, ," 2011, forthcoming in forthcoming in Oxford Review of Economic PolicyOxford Review of Economic Policy..““A Solution to Fiscal Procyclicality:  The Structural Budget Institutions Pioneered by Chile,” ,” Fiscal Policy and Macroeconomic Performance, Fiscal Policy and Macroeconomic Performance,  Central Bank of Chile, 2011.  NBER  Central Bank of Chile, 2011.  NBER WP 16945, WP 16945, April 2011. 2011. “The Estimated Effects of the Euro on Trade:  Why are They Below Historical Evidence on Effects of Monetary Unions Among Smaller Countries?” in ” in Europe and the Euro, , Alberto Alesina Alberto Alesina & & Francesco Giavazzi, eds. Francesco Giavazzi, eds. (U.Chic.Press), (U.Chic.Press), 2010.    2010.    "Comments on 'The euro: It can’t happen, It’s a bad idea, It won’t last. U.S. economists "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. on the EMU, 1989-2002,' by L.Jonung & E.Drea," slides. Euro at 10: Reflections on Euro at 10: Reflections on American ViewsAmerican Views, ASSA meetings, San Francisco, 2009. , ASSA meetings, San Francisco, 2009. "The UK Decision re EMU: Implications of Currency Blocs for Trade and Business "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: Cycle Correlations," in Submissions on EMU from Leading Academics (H.M. Treasury: London), 2003.London), 2003."The Endogeneity of the Optimum Currency Area Criterion" (with Andrew Rose),    "The Endogeneity of the Optimum Currency Area Criterion" (with Andrew Rose),    The The Economic JournalEconomic Journal, 108, no.449, July 1998., 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: Interest rate penalties on the bonds

of overly indebted US states

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Spreads help keep profligate US states in lineSpreads help keep profligate US states in line= reason why no state has ever been bailed out by = reason why no state has ever been bailed out by

the Federal government, despite some defaults.the Federal government, despite some defaults.

22Source: W.B. English, „Understanding the costs of sovereign default …,“ p. 269. as used by Holtfrerich (2011)Holtfrerich (2011)

Yield tomaturity

in %

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California Municipal BondsCalifornia Municipal Bonds(now the lowest rated of the 50- states)(now the lowest rated of the 50- states)

Credit Default SwapsCredit Default Swapshttp://blogs.reuters.com/muniland/2011/06/08/muni-sweeps-lockyer-rides-again/http://blogs.reuters.com/muniland/2011/06/08/muni-sweeps-lockyer-rides-again/

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Appendix B: Appendix B: Proposals for the future #1Proposals for the future #1

Emulate Chile’s successful fiscal institutionsEmulate Chile’s successful fiscal institutions

a)a) Phrase budget targets in structural terms,Phrase budget targets in structural terms, which is also the Swiss rule.which is also the Swiss rule.

b) Give responsibility for determining what is b) Give responsibility for determining what is structural to an independent professional structural to an independent professional agency, to avoid forecast bias.agency, to avoid forecast bias. (Frankel, 2011)(Frankel, 2011)

Even Greece’s primary budget deficitEven Greece’s primary budget deficithas been far in excess of 3% since 2008has been far in excess of 3% since 2008

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Source: IMF, 2011.I. Diwan, PED401, Oct. 2011

Even though in most years true Greek budget deficitsEven though in most years true Greek budget deficits were far in excess of the supposed limit were far in excess of the supposed limit (3% of GDP).(3% of GDP).

2626Source: Frankel & Schreger (2011)

the the official budget forecasts were always rosy.official budget forecasts were always rosy.

Until, in 2009, the bottom fell out of the budget.

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Proposals for the future: #2Proposals for the future: #2

PenaltyPenalty when a euro country misses its target:when a euro country misses its target:

a)a) The ECB then stops accepting new bonds as collateral.The ECB then stops accepting new bonds as collateral.b)b) => Sovereign spread rises, with automaticity.=> Sovereign spread rises, with automaticity.

c)c) Proposal from BrueghelProposal from Brueghel (JvW & ZD): (JvW & ZD): All of euroland is liable for All of euroland is liable for blue bondsblue bonds

(issued up to SGP limits); (issued up to SGP limits); Issuing country is liable for Issuing country is liable for red bondsred bonds

(beyond those limits) .(beyond those limits) .

d)d) Blue bonds share advantages with other eurobond proposals:Blue bonds share advantages with other eurobond proposals:a)a) ● ● ECB can conduct monetary policy.ECB can conduct monetary policy.b)b) ● ● They could offer an alternative to US TBills They could offer an alternative to US TBills

for PBoC & other desperate global investorsfor PBoC & other desperate global investors

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Blue bonds & red bondsBlue bonds & red bonds

Gavyn Davies, FTSource: