Session 5: Adjustment in the Euroarea

Jun 28th, 2010 | Category: Session 5

25 June 2010

The session looked at two main topics:

1. adjustment issues focusing on the fiscal consolidation challenge,

2. euro area enlargement prospects.

How much is too much public debt? For example, after the World War II, UK’s public debt reached 230 percent of GDP, which did not cause a problem. But in late 2008 Latvia could not finance its budget deficit from the market despite the fact that its public debt was a mere 15 percent of GDP. The question remained unanswered, because neither economic history nor theory provides a reference value, but the discussion highlighted several factors to consider. For example,

• market perceptions (markets have been inconsistent with respect to public debt levels);

• the ability to act by the government;

• whether residents (as eg in Japan) or non-residents are the main holders of the debt;

• whether private debt carries a significant danger to turn to be public debt;

• fiscal dominance (monetary policy is determined by the fiscal situation).

Regarding the high debts after WW-II, it was emphasized that this period was characterised by low interest rates and price controls. The current crisis has shown that low public debt levels can easily also easily explode: eg Irish public debt was 25 percent of GDP in 2007, which is seen to increase to 87 percent by 2011 according to current forecasts.

Fiscal consolidation – other aspects to consider:

• whether the actual deficit is the result of a permanent output loss, or a temporary negative output gap;

• whether the sacrifice required by fiscal adjustment is socially sustainable;

• whether non-Keynesian effects may be at work;

• accompanying structural reform measures are inevitable.

Probability of success:

• Fiscal adjustments that cut public wages and current spending have higher probability of success

• Increase the share of tax revenues = higher probability of success

• Increase the share of public investment = higher probability of success

• Accompanied by structural reforms = higher probability of success

Spain versus Greece. It was suggested that the case of Spain was very much dissimilar to that of Greece. The latter suffered from high deficit and debt levels. The Spanish fiscal position was under control before the crisis, but relied heavily on revenues related to real estate activities, and a large share of such revenues are permanently lost. The sharp rise in unemployment causes significant expenditure rise.

Spain has announced consolidation measures in three main waves: in September 2009, in March 2010, and in May 2010; the latter was primarily motivated by contagion fears from Greece. Most of the correction is achieved on the expenditure side of the budget, including an average five percent cut in nominal wages in the public sector in 2010 and a freeze in subsequent years, and curbs in various social expenditures. The consolidation is augmented by a major labour market reform and restructuring of the financial sector, which increase the probability of success.

EMU enlargement

Estonia will join the euro area in 2011 as the 17th member.

Should the door close after Estonia joins? There was a debate whether the door can be closed at all: enlargement is largely a legal process, and without a Treaty change, it can not be made neither harder, nor easier. But there are still rooms for subjective decisions:

• According to the Treaty, the convergence criteria must be met in a sustainable way, which involves an assessment. The Commission has the right to make the proposal to the Council based on its and the ECB’s assessment. Eg in 2006 Lithuania, which missed the inflation criterion by only 0.1 percentage point and easily met all others, was not proposed by the Commission and therefore the Council did not have a chance to form an opinion.

• Applicants must respect the normal fluctuation band of the ERM-II regime for at least two years prior to examination, which is interpreted as the necessity of ERM-II participation (though there were three applicants so far that have not spent two years in ERM-II prior to their examinations, but were allowed to join the euro). The ECB has a decisive power on the admission to ERM-II. Eg Bulgaria that wanted to enter ERM-II right after it has entered the EU has not yet been allowed to enter. Being a member of ERM-II, Bulgaria would have likely joined along with Estonia (inflation fell due to the crisis, public debt is below 15 percent of GDP, and just a small additional adjustment would have been needed to meet the deficit ceiling, as the 2009 deficit was at 3.9 percent).

• The Treaty sets the benchmark for the inflation and interest rate criteria on “the three best performing member states in terms of price stability”, but does not specify hot to determine the three best performers. The current practice (the three countries with the lowest, but not negative inflation rate) is highly questionable, and nothing would prevent the ECB and the Commission to interpret the Treaty in a more meaningful way.

• The Treaty allows (if fact: obliges) the Council to change the Protocol (that describes the measurement of the convergence criteria) with a unanimous decision, ie the measurement can be changed without a Treaty change.

Considering the points of view of current euro area members, the main argument for not letting countries new candidates to join is the potential of Eastern newcomers to became a “new Spain”, ie to undergo a severe boom-bust cycle, or to become a “new Portugal”, ie not be able to adjust competitiveness within the euro area and deliver low economic growth even in good times. Other popular arguments are not well founded (eg to avoid importing countries that have a potential for a Greek-type fiscal crisis; ‘we are in the midst of governance reform’, high inflation in newcomers will require low inflation in the old to meet ECB target; lessen the credibility/stability of the euro). Further, keeping countries out would deliver an unacceptable political message and could cause instability at the border of the euro area. Furthermore, new EU member states are still seen to by more dynamic than the current euro area, which would bring benefits.

Should outsiders rush to join? The potential to repeat the experience of Spain (unsustainable housing booms followed by a deep recession with severe impact on unemployment) is a real danger. Several Central and Eastern European countries have suffered from such a development even outside the euro area.

Countries that face fast economic catching up and consequently price level convergence may find it better to stay outside the euro till a higher level of real convergence is achieved.

Pre-crisis credit booms. There was an interesting debate about the responsibility for the huge pre-crisis credit booms in some of the new EU member states. Many agreed that the financial sector had a key role in these booms, and also that home authorities have not done much when they observed that their banks expand credit at an unsustainable rate in the East. But there was a disagreement on the role home authorities. Some argued for the complacency of local central banks, while others questioned complacency and instead emphasized the lack of instrument in a financially integrated environment, in which the local banks are dominantly foreign owned. Croatia, for example, tried to limit lending (and foreign currency lending in particular) in various ways, that was not done by many new EU member states, but Croatia’s efforts proved to be rather ineffective.

Differentiation with the group of new EU member states. It was also highlighted that the new member states constitute two very distinct groups. The ‘bubble-economies’, ie Baltics, Bulgaria and Romania, and the central European economies (Hungary is at the border line of these two groups). The previous bubble-countries should adjust their earlier growth model, but in the second group the growth model seems largely sustainable and desirable. Interestingly, countries in the more troublesome first group wish to join as soon as possible, while after the entry of Slovenia and Slovakia, the remaining three countries in the second group (Czech Republic, Hungary, and Poland) are not in a hurry.

Path dependency. Countries with fixed exchange rates and huge € liabilities should not risk a floating regime due to devastating balance sheet effects (as a result of a possible sizeable exchange rate overshooting). These countries should aim to join, but only if labour market adjustment proves to be sufficient, plus they can redirect the growth model of their economies from ‘bubble’-based growth to competitive manufacturing sector based growth.

Traditional optimum currency area criteria vs the convergence criteria. A shared conclusion was that the traditional optimum currency area criteria matter, which is supported by the experience of both euro-area members and outsiders. Yet the current convergence criteria may be partially rehabilitated: those countries suffered the most and ended in weak competitive positions both inside the euro area and outside that had high inflation. But certainly, the current measurement, one year compliance (that can be easily manipulated) and using the three lowest inflation EU member state as a benchmark (that does not make sense) should be reformed.

Rapporteur: Benedicta Marzinotto and Zsolt Darvas, Bruegel

• Carlos Mulas-Granados,“Fiscal Policy in Debt Ridden Countries”

• Zsolt Darvas, “Fiscal Federalism in the crisis: lessons for Europe from the US”