The Future of the Euro: The Options for Finland¹ - PDF

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ömmföäflsäafaäsflassflassflas fffffffffffffffffffffffffffffffffff Discussion Papers The Future of the Euro: The Options for Finland¹ Vesa Kanniainen and the EuroThinkTank of Finland University of Helsinki and HECER Discussion Paper No. 383 September 2014 ISSN ¹This report is based on a book published on 7 May 2014 by Libera Foundation and produced by the EuroThinkTank of Finland. The research group worked in the facilities of the University of Helsinki having as members Vesa Kanniainen (Chairman), Jukka Ala-Peijari, Elina Berghäll, Markus Kantor, Heikki Koskenkylä, Pia Koskenoja, Elina Lepomäki, Tuomas Malinen, Ilkka Mellin, Sami Miettinen, Peter Nyberg and Stefan Törnqvist. This report was previously published in CESifo Forum 3/2014, September. HECER Helsinki Center of Economic Research, P.O. Box 17 (Arkadiankatu 7), FI University of Helsinki, FINLAND, Tel , Fax , Internet HECER Discussion Paper No. 383 The Future of the Euro: The Options for Finland Abstract The report raises the following questions: (i) Why is the eurozone in crisis? What is the magnitude of the welfare losses the crisis has led to? (ii) Do the political union, banking union and fiscal union represent solutions that promote democracy, economic efficiency and the general welfare and security of the citizens? (iii) Is a full-blown federation a better option than the current trend towards a weak federal state, or are we heading for the readoption of national currencies? (iv) What are the options available for Finland? Therefore, the deviations from the optimal currency area are examined and the pre-crisis monetary policy assessed. The accumulated welfare loss arising from euro to the member countries is estimated. The potential futures of euro are assessed in terms of a weak federation, strong federation and return to national currencies. The three options available for Finland are evaluated in terms of driftwood (Option N:o 1), keeping options open (Option No. 2) and Fixit, return to the Finnish markka (Option No.3). JEL Classification: E42, E44, E52, E58, F33, F34, F36 Keywords: euro crisis, welfare loss of euro, future of euro, options for a single member country Vesa Kanniainen Department of Political and Economic Studies University of Helsinki P.O. Box 17 (Arkadiankatu 7) FI University of Helsinki FINLAND 1 1. Introduction The European Monetary Union was a political project. The uncertainty factors involved were disregarded, even though many economists, especially in the USA, warned of the risks. Unfortunately, those words of caution have come true. The EuroThinkTank of Finland, a working group representing economists, experienced professionals in the financial sector and a statistician took it upon itself to analyse the underlying reasons of the economic and political crisis afflicting the eurozone and to assess the future of the euro. Of special interest to the group was to examine the options available to Finland, a small euro member. The think tank members were united by a sense of disappointment with the economic development of the eurozone, the rhetoric nature of the policy on the euro and the lack of diversity in the argumentation related to the assessment of its performance. The report raised the following questions: (i) (ii) (iii) Why is the eurozone in crisis? What is the magnitude of the welfare losses the crisis has led to? Do the political union, banking union and fiscal union represent solutions that promote democracy, economic efficiency and the general welfare and security of the citizens? Is a full-blown federation a better option than the current trend towards a weak federal state, or are we heading for the re-adoption of national currencies? (iv) What are the options available for Finland? The think tank held that the foreseen political union including the banking union and fiscal union will push the eurozone towards a sort of practical federal state, referred to as the 'weak federation'. It has also transpired that conflicts of interest between individual member states cannot be overlooked in the assessment of the future evolution of the eurozone. States facing a sovereign debt crisis demand that their problems be resolved through solidarity, while member states that have put in a better performance in looking after their public finances object to joint liability. The report conveyed a message to Finland's political decision makers: Finland has a range of options, including the current 'driftwood option', a unilateral return to the Maastricht Treary (Maastricht 2.0) with an option to abstain from a further step of integration, and Fixit, an immediate return to the national currency. 2 2. Why The Euro Crisis? Reasons behind the euro crisis have been extensively discussed by the economic profession. The book of the EuroThinkTank of Finland reviewed those reasons including the labour market mechanisms and the resulting current account problems. Moreover, a lot of attention was devoted to the financial issues, i.e. excess liquidity created in the eurozone. True enough, progress was made with integration but cross-border financing contributed to debt bubbles. As banks with distorted balance sheets became increasingly dependent on short term borrowing instead of traditional deposits, they also became more exposed to disruptions. Most importantly, the debt markets were fuelled by cheap money, for which favourable conditions were created by the key central banks, the ECB included. During the euro's lifetime, the financing base of the banking sector crumbled and its size relative to the production capacity of the eurozone grew out of proportion. Large banks became oversized banks. The book took the view that to understand the creation of excess liquidity, one needs to have a closer look into the monetary policy of the ECB. Often, underlying credit expansion is lax monetary policy. The crisis originating in the USA in 2008 can be traced back to lax monetary policy coupled with failed housing market policy and, in particular, shadow banking operations. Also, there were regulatory failures in the supervision of the markets and financial institutions. The ECB's monetary policy in the 2000s, the years leading to the euro crisis was lax, too. According to the chart below, the M3 money supply was growing in the eurozone by 106% during while the average annual growth rate should have remained at 4.5% according to the first pillar of the Maastricht Treaty. CHART 1. Growth rate of money supply (M3) and lending by financial institutions in the eurozone Source: ECB 3 In the 1990s, the monetary authorities on both sides of the Atlantics were perhaps thinking that the stance of monetary policy with low interest rates is sound enough as the rate of inflation is under control. What this view misses is the fact that the rate of inflation was down because of the globalization process based on low-cost production in the developing countries. Underlying the easy accumulation of debt was the evolution of the European bond market. Central to these developments were the arrangements made by eurobanks and the ECB, which gave added impetus to the growth of debt. Several handicaps have been identified in the development of The European Monetary Union. The most fundamental one, however, is the political one. The leaders in the euro zone area did not show strict commitment to the jointly designed rules of economic policies. The economic relations between the US Federal Government and the states, on the contrary, have been since 1840 governed by a strict no-bailout policy. The Fed doesn't hold bonds issued by the states in its portfolio. 3. THE WELFARE LOSS OF THE EURO COUNTRIES An argument can be put forward that the eurozone would have tumbled into difficulties even without the shock originating in the USA. The book provides a statistical assessment of the potential size of the cumulative welfare loss incurred by the euro members. It is based on the evolution of the eurozone GDP relative to the recovery of a reference economy, the US. While the statistical link in real growth of the GDP between the USA and the EMU was extremely strong up until the end of 2007, it has since then broken. The assessment was made using several statistical models based on one-step forecasts. In a sense, the cumulative welfare loss measures the distance by which actual GDP has fallen behind the potential GDP. The idea is that the USA's GDP serves as a surrogate variable for a larger set of phenomena affecting the GDP in the eurozone. 1 The following models were used 2 : Stochastic difference equation: the actual evolution of eurozone's GDP was explained by its built-in delay structure and the actual evolution of the USA's GDP. VAR model: actual real GDPs of the eurozone and the USA in inter-dependency. VARX model: eurozone's and Finland's GDP were explained by USA's GDP in addition to the built-in delay structures. The results are summarized as (i) Using the stochastic difference equation, the difference between the prediction yielded and the actual GDP produced a cumulative prediction error of in the prediction period after 2007 IV. This shows how much the volume index of the eurozone GDP falls short of what was predicted by the model by 2013 III. CHART 2. STOCHASTIC DIFFERENCE EQUATION: CUMULATIVE PREDICTION ERROR 1 2 The models were estimated using observations from the period 1995 I 2007 IV. All the time series used in the models consisted of seasonally adjusted quarterly GDP time series (in levels). After estimation, the models were used to generate a statistical prediction showing how the GDP would have been expected to develop if the laws operating prior to the euro crisis had applied during the period 2008 I 2013 III covered by the prediction. The predictions were single-step predictions formed by inserting the actual values of the GDP variable to be predicted in the estimated model equation in an effort to ensure that the prediction is as sound as possible in terms of its statistical properties. The models were subjected to diagnostic validation and the adequacy of the model with respect to the remainder term is determined in the 'Hendryan' (Hendry (1959)) spirit of statistical deduction. 4 (ii) In the VAR model, the cumulative prediction error yielded by the VAR model was (iii) In the VARX model, the prediction error was The claim that poorer performance in crisis management as compared to the USA is due to the eurozone itself its inherent structural flaws and/or policies is plausible. This view is supported by several observations: (i) Before the USA-induced economic shock, developments in the eurozone followed the economic development of the USA quite closely. From , the real rate of growth in both regions was 2.3%. (ii) Although the USA succeeded in getting back on the growth track fairly quickly after the economic crisis, the eurozone has failed to do so. (iii) The stagnation of the eurozone is not due to other developments in the global economy. No shocks have been sent to the eurozone by the world economy that would explain the halt of the region's economic growth. Economic history suggests that even a minor difference in growth rate may, with time, lead to a dramatic cumulative loss. Chart 3 illustrates the real per-capita growth in GDP from in Great Britain, the United States, Sweden and Finland. A significant observation is made: by the year 1985, the world's wealthiest nation (Great Britain) slips to the last place with the lowest income level in this group posting a total per-capita income that is only two-thirds of that of the USA. This dramatic cumulative welfare loss is a result of the difference in the average growth rate between the USA and Great Britain a mere 0.4 percentage points per year. The key question in evaluating the crisis facing the monetary union is the effect of the new EMU institutions on economic growth and the wellbeing of citizens. CHART 3. 5 Growth rates in Great Britain, USA, Sweden and Finland ( ) in terms of purchasing power parity. Source of data: Bolt and Van Zanden (2013) 4. THE PLANS FOR AN EXTENDED INTEGRATION IN THE EUROPEAN MONETARY UNION Germany is emerging as a key player in the long-term evolution of the EU institutions. The body politic in Germany wishes to turn the monetary union into a political union. According to German political thinking, supported by all major parties, the political union would consist of a banking union, a fiscal union and an economic union. Through its current account balance, Germany funds other euro members. The estimated cumulative surplus of the current account already exceeds EUR 1,000 billion. 3 Germany also benefits from a weak euro relative to the country's competitiveness. It has been estimated that if Germany had its own currency, its value against the US dollar could be as high as 1.60 whereas the euro-dollar exchange rate now trades around 1.38 (March 2014). Is a currency union viable without a political union? There are no examples in world history of successful currency unions between independent states. All successful common currency mechanisms that have been in operation for any longer periods of time have been either federal states or confederacies (Bordo and Jonung 1999). The IMF has, however, suggested that a full-scale implementation of a banking and fiscal union would save the euro and secure stability in the eurozone. 4 The ambition to develop the eurozone's economic and monetary union into a fiscal 3 De Macedo and Lempinen (2013). 4 IMF Staff Discussion Note, A Banking Union for the Euro Area, February 2013; IMF Staff Discussion Note, Toward a Fiscal Union for the Euro Area, September 2013. 6 union is expressed in the report 'Towards a Genuine Economic and Monetary Union' published on 5 December It was signed by the President of the European Council; the Chairman of the European Commission; the President of the Eurogroup; and the President of the European Central Bank. The objective of the road map is to establish a community-level financial policy based on joint liability in order to manage economic disruptions. It would be based on increasing community-level decision making. It is foreseen to lead to growing coordination of the economic policies of the member states, specifically in taxation and the efforts to address unemployment. To strengthen the fiscal capacity of the EMU, plans are in place to introduce a community-level unemployment security system to replace equivalent national schemes. Money to finance the common funding scheme would be raised from national sources. Community resources would be strengthened by issuing community-level bonds. The ultimate goal of the fiscal union is seen in the creation of the European Ministry of Finance. The roadmap for the fiscal union highlights the short-term stabilisation needs of the monetary union. In a federation, it would be natural for the community to take care of the stability policy. When responsibility for the monetary policy rests with the ECB, evidently the responsibility for financial policy and macro-economic stabilisation would fall on the Commission and the European Parliament (or an equivalent agency to be created for the euro countries). A fiscal union would be tasked to produce public goods (security, social services) and certain private goods (health care, education), to create a social assistance system (unemployment benefits), establish a just income transfer system, and manage the stabilisation policy. Fiscal federalism as an economic architecture should be evaluated in terms of whether it increases economic efficiency. The book by the EuroThinkTank reviewed such a plan. 5. THE ALTERNATIVE FUTURES OF THE EUROPEAN MONETARY UNION 5.1 Conflicting interests The eurozone's growth prospects are so bleak that its welfare losses relative to normal economic development and growth may well persist for a long time to come. From the point of view of the future of the monetary union, what is decisive, however, is what happens to the large euro members. Italy, Spain and France are facing major problems. The economic crisis in the eurozone has also led to divergence of the member states' interests. Southern members hold that they are entitled to income transfers from northern members. The former advocate eurobond-based joint liability in financing budget deficits, re-distributing the cost of over-indebtedness, managing the potential support measures required by eurobanks, and putting in place a joint deposit insurance. 5.2 The possible futures The current state of the eurozone, often referred to as the EMU-2, means a departure from the Maastricht Treaty ( Maastricht 1 ). The principles of 'no bailout' and the non-involvement of the ECB in supporting any individual country have ceased to apply. Most likely, the current situation, EMU-2, is just an intermediary phase. It has become evident that the Commission and the ECB will, in accordance with their respective missions, step by step take measures that will willy-nilly steer the development of the Union towards deepening integration and centralised decision-making. It appears that the entire eurozone has only two stable options that do not involve any internal tensions regarding further development of the system: (i) (ii) A strong federation consisting of the 18 euro members. A return to national currencies, meaning the type of EU membership alike Sweden and Poland. 7 However, each individual country can determine the preferred level of integration for its own part. If this happens, a part of the eurozone may evolve into a federation whose currency is used by a group of member states content with a lower level of integration. Consequently, the member states have four options: (i) (ii) (iii) Membership in a weak euro federation (like today; most likely just a temporary solution). Membership in a strong euro federation (likely outcome of the planned development of the EMU over the long term). Keeping the euro but staying outside of any alliances. (iv) Adoption of a national currency or exit from the euro. 5.3 EMU-2 as a weak federation Based on EMU-2, the eurozone would evolve into a temporary federation of independent states which would, step by step, be strengthened by new decisions. The banking and the fiscal union may just be enough to restore permanent stability to the finances of the member states and banks. This time around, the member states might actually stick to the agreements made. In case of a new financial crisis, the last resort would again be the ECB's extreme monetary policy measures. 5 The capacity of the weak federation to generate welfare may be compromised. Ample evidence shows that regulators repeatedly fail to prevent banking crises. This creates pressures to introduce joint liability sooner or later. Financial policy guidance and control are based on the restrictions imposed by regulators instead of continuous and flexible assessment made by the markets, i.e. market discipline. Economic history lends no support to the notion that banking crises could be prevented by supervision. Instead, banking crises can only be averted through the introduction of the right incentives within the banking system itself. 5.4 A strong federation as the true political union There are well-functioning federations in the world such as the USA, Germany and Switzerland. Invoking the example of the USA, one could argue that the main task of a strong federation is to produce public goods (national security, foreign policy and a free internal market as a minimum), provide social security for the citizens and assist the member states in the event of asymmetric shocks. Characteristic of a strong and successful European federation is that it would work largely in the same way as existing federations. 6 The EMU's prospects for becoming a successful federation appear quite bleak, and for a long time to come. The applicable criteria could be outlined as follows: Su
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