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Departures from optimum currency area criteria

Currency area theory is concerned with extent to which efficiency gains from currency area membership are offset by losses due to increased vulnerability to external economic shocks, and the term "optimum currency area" (OCA) denotes an area in which such offsets are absent. Although an idealistic concept, it has practical implications because the increased costs of recessions, brought about by increased vulnerability to shocks, can be large compared with the benefits of the efficiency gains. For that reason it is generally accepted that a currency area may not succeed unless it goes a substantial way toward meeting OCA criteria. A currency area fully meets OCA criteria if there is complete price flexibility, or complete cross-boarder mobility of labour and capital. An alternative requirement arises from the fact that increased vulnerability to shocks need not occur if every shock has the same impact on all the economies of the member states. The term "convergence" is sometimes used to denote a condition in which the economies of members states are so similar as to eliminate asymmetric shocks - or to denote an approach to that condition.

The eurozone has not satisfied the OCA labour migration or price flexibility conditions. Labour mobility is low and there is only limited wage and price flexibility. Nor has it satisfied the convergence condition. There has been less price convergence among eurozone countries than among European Union countries as a whole,, and there have been large divergences of productivity, unit labour costs, and current account balances. The progress toward convergence as a result of membership, that was expected by the early proponents of monetary union, has not occurred.

The debt trap

If the annual interest payable on a government's debt were to continue to rise faster than the national income, it would eventually exceed the feasible revenue from taxation. The process is normally hastened by the fact that government debt is traded in a well-informed market. Operators in that market would be aware of the approach of the point at which the government would be forced to default on its debt, and they would be increasingly reluctant to allow that government to continue to roll over its debt. The government concerned could seek to overcome that reluctance by offering them higher interest on future loans, but an increase in the interest to be paid would hasten the process and increase the reluctance of further potential investors. That is what is known as the debt trap, the price formulation of which is the the debt trap identity.

The debt trap could be escaped:

- (i) by repudiation of the debt;

- (ii) (temporarily) by a negotiation with creditors to ease the terms of repayment (termed restructuring);

- (iii) (temporarily) by getting the country's central bank to purchase the debt; or,

- (iv) by a programme of reductions in public expenditure and/or increases in rates of taxation.

Options (i) and (ii) have the drawback of making future investors reluctant to buy the government's bonds. Option (iii) can also have that effect if it causes an inflation that reduces the value of the currency in which the debt is to be repaid. Option (iv) is free from that drawback, but is effective only if it avoids creating a recession that increases the deficit (by the operation of the country's automatic stabilisers).

Fewer options are available to members of a currency union, however. Option (iii) may be excluded by the fact that monetary policy is no longer under the control of the borrowing government. That fact also prevents the use of monetary policy to counter the recessionary consequences of (iv), (without which that option may be ineffective); and the rules of the currency union prevent the exchange rate deprecation that might otherwise counter them. To make (iii) possible and (iv) easier, a further option would be (v) - to leave the currency union.

Policy options

Conditional loans

The EU/IMF loans had been primarily intended to restore the confidence of the bond markets in their recipients' ability to meet their financial obligations and give the recipient governments time in which to restore their fiscal sustainability, and have been conditional upon the adoption of stringent fiscal adjustments. Since May 2010, the EU components of such loans have been supplied by the European Financial Stability Facility subject to the approval of the parliaments of the eurozone countries. Proposals to refinance the Facility by using the Europan Central Bank have not been adopted and, as it stands, it is too small for rescues of the larger eurozne countries such as Spain and Italy.

Bond guarantees

As one means of "leveraging" the European Financial Stability Facility, it has been proposed that it should offer partial guarantees against loss by a purchaser of a member government's bonds, for example by assuming a portion ofthe loss amounting to a stated percentage of the issue value of the bond.

Co-investment funds

Another form of leverage is the creation of a co-investment fund to enable the deployment of a combination of European Financial Stability Facility and private sector resources.

Bond purchases

Before May 2010, the European Central Bank had used bond purchases only for the purpose of monetary policy, but in May 2010, in a major policy change, it decided to buy European government bonds in order to assist governments who were experiencing funding difficulties - a policy change that was opposed by Axel Weber, the then President of the German central bank. Purchases are reported to have included the bonds of all of the PIIGS countries, including Spain and Italy.

The ECB as lender of last resort to member states

It has been proposed that, instead of the provision of loans at the case-by-case discretion of member countries, the duty should be placed upon the European Central Bank to provide assistance to member governments when it is needed, raising the necessary funds by monetisation. The proposal has been rejected on the grounds of fear of moral hazard and of the possible creation of inflation as a result of the consequent increase in the money supply.

Eurobonds

In December 2010, two Eurogroup finance ministers put forward a proposal under which bonds issued by individual governments would be collectively guaranteed by the other eurozone governments, . In August 2011, the financier George Soros argued that eurobonds would have to be an essential feature of any effective Greek rescue package, an assessment that was endorsed by the eminent economist, Joseph Stiglitz . Among variants on the concept are the "Blue Bond" proposal, under which eurozone governments would pool up to 60 percent of GDP of their government debt in the form of a common European government bond , and its "partial sovereign bond insurance" alternative .

In November 2011, the European Commission published an analysis of the pros and cons of three alternative of eurobonds (which they dubbed "stability bonds"):

(a )the full substitution by stability bond issuance of national issuance, with joint and several guarantees:

(b) the partial substitution by stability bond issuance of national issuance, with joint and several guarantees: or,

(c) the partial substitution by stability bond issuance of national issuance, with several but not joint guarantees:

Fiscal integration

It has been argued by the economist Wolfgang Münchau, and others, that the eurozone embodies a logical inconsistency that will continue to make it vulnerable to economic shocks unless it is resolved by the introduction of some form of fiscal union. There have been a number of proposals that would serve the purpose without the imposition of a common budget. The decision of 9th December proposed that eurozone countries should be required to present their draft budgets to the European Commission, and that they should be submitted to the European Court of Justice for validation of their compliance with federal law - so that an invalidated national budget would be illegal.

Restructuring of debt

It is generally accepted that the costs of sovereign default to all concerned are such as to make its avoidance a high priority objective. But it has been argued that, when default becomes unavoidable, some of those costs can be avoided by a timely "restructuring" agreement with the country's creditors. In May 2011, European Finance Ministers discussed the possibility of a rescheduling of the Greek government's debt (also referred to as "soft restructuring" or "reprofiling")', and a reduction by half of Greece's debt, was subsequently adopted as one of the decisions of October 2011.

Bank recapitalisation

European banks had already suffered reductions in their assets as a result of falls in the value of their holdings of Greek bonds, and a resulting reductions in their capital adequacy ratios had resulted in their failure to pass stress tests . Further large-scale recapitalisation, was considered in October 2011 to be a necessary adjunct to the restructuring of the Greek government's debts without which it would result in multiple bank failures.

Internal devaluation

Since it is not open to eurozone governments to increase the international competitiveness of their countries' products by devaluation, some have sought to do so by measures to reduce the costs of production, for example by reducing the tax wedge that raises the cost of labour to employers above the take-home pay of employees. The same objective may be served by the downward pressure on wage rates brought about by increases in unemployment resulting from fiscal adjustments designed to restore sustainability.

Exit from the eurozone

Departure from the eurozone would enable a country to monetise its debt, and would offer the prospect of an increase in competetiveness resulting from a currency devaluation. However, according to a study by UBS economists, the benefits to a country like Greece would be overwhelmingly outweighed by costs. It would also result in mass sovereign and corporate default, a major increase in the cost of capital, and the collapse of its banking system (the first-year cost of its departure was later estimated to be 40 to 50 per cent of GDP. ). The economic commentator, Anotole Kaletsky, has argued that the "seemingly impossible" solution of a German exit might become inevitable, and would be much less disruptive than a Greek expulsion because it would not trigger bank runs in countries, but would enable a devalued euro to be managed on less austere principles. But the UBS economists estimate that departure of Germany would lead to a first-year loss to its economy of 20 to 25 per cent of GDP.

Policy constraints

Overview

The principal alternatives that have been put forward to the current policy responses to the crisis have been (a) the extension of the European Central Bank's limited practice of government bond purchases to the point of giving it the obligation to serve as member governments' lender of last resort, and (b) the issue by individual member government of eurobonds that would be jointly guaranteed by member states as a whole. The reason that has been put forward for their rejection by the eurozone's decision makers has been the fear that the moral hazard that is associated with financial rescues, would lead to reckless conduct by member governments, of the sort that would increase the prospects of a recurrence of the crisis. To counter that fear, it has been proposed that member governments should be required to submit budget proposals to the European Commission for approval, but there are doubts whether national parliaments would assent to such a surrender of sovereignty.

Institutional constraints

The European Central Bank

The European Central Bank would be able to make a decisive response to the crisis were it not for the constraint of its mandate, and were it not for the restrictive interpretation that it applies to its function. Article 123 of the Treaty on European Union prohibits it from buying bonds directly from member governments, so that an amendment to the treaty would, in principle, be necessary to enable it to act as their "lender of last resort" (there have been some small-scale purchases on the secondary market, however).

Treaty limitations apart, the Bank appears unlikely to adopt such a rôle. The economist Bradford DeLong has observed that, in a "radical departure from the central-banking tradition", the European Central Bank does not consider financial stability to be part of its core business . Statements by its governors confirm that they consider its function to be the avoidance of inflation, and that they would be very reluctant to use its powers for other purposes. Some of the Bank's governors have even opposed the minor interventions that have been made.

On December 1, the Bank's new President Mario Draghi said that more aggressive action would be taken to assist banks and governments if governments were to adopt a new "fiscal compact.", but on 8th December he rejected the idea, claiming that he had been misunderstood.

The European Commission

The Commission has put forward its proposals for the introduction of eurobonds and for improved fiscal integration but, although fhe European Union's treaties authorise the Commission to take the initiative in proposing legislation, legislative decisions (except those concerning competition policy) can be taken only by the Council of Ministers and the European Parliament.

National attitudes

Germany

With the largest of the eurozone's economies, and as the largest contributor to its rescue measures, Germany's attitudes have necessarily had a decisive influence on the eurozone's response to the crisis, and the European press is virtually unanimous in the belief that its Chancellor, Angela Merkel dictates her conditions on what should be done..

The German Government is opposed to "any participation of the European Central Bank in the strategies to resolve the euro debt and banking crisis". It is also opposed to the European Commission's eurobond proposal. Chancellor Merkel described the proposal as "extremely regrettable and inappropriate", arguing that the case for it should be put at the end of the process of European integration, "if indeed it is put at all". Newspaper reports in Germany indicated that some within her Christian Democratic Union Party and the Christian Social Union might be willing to relax their objections to intervention by the European Central Bank if it were made conditional on the introduction of an effective system of fiscal integration . It became apparent, however, that their attitude was not shared by the leadership, which continued to reject all forms of short-term action, and to concentrate solely upon the terms of an eventual fiscal union.

According to a YouGov poll held in August 2011, most Germans disapprove of their government's handling of the crisis (75%), and they want no more bailouts (59%), but want Greece expelled from the eurozone (58%). But German opinion is dividided on the question whether Germany should leave the eurozone (44% for/48% against) . In a further YouGov poll , the majority of respondents approved the decisions of 9th December, but did not expect them to help the crisis, and there was a small balance of confidence in Chancellor Merkel (56 against 40).

There have been signs that Angela Merkel's coalition government has been losing popular support , but federal elections are not due until 2013.

France

France's President Sarkozy is reported to favour both the eurobond proposal, and the proposal to use the the European Central Bank as lender of last resort, but to be willing to avoid public statements of disagreement with Chancellor Merkel. However there is to be a presidential election in April 2012 and December opinion polls indicate that most French people are opposed to the new fiscal compact.

Italy

Italy's Mario Monti has said that "stability bonds ... might actually make a contribution but it must be done within a fiscal union

Others

On a visit to Berlin on 28th November, the Polish Foreign Minister attacked the German Government's policy with the words " we ask that Germany admits that she is the biggest beneficiary of the current arrangements and therefore that she has the biggest obligation to make them sustainable" and called for immediate action to strengthen fiscal coordination and to make the European Central Bank the eurozone's lender of last resort. Support for increased use of the European Central Bank was also expessed by Finnish and Belgian Ministers.

The Dutch Finance Minister has been quoted as saying "in the long term I do not exclude Eurobonds. But we have to do necessary things first. That means strict surveillance and enforcement of budgetary discipline".