CAN THE EURO BECOME A MAJOR CURRENCY DESPITE WEAK INTERNAL

GOVERNANCE?

Presentation by Niels Thygesen*At IV ASTANA Economic Forum

3 May 2011

*Professor (emer.) of Economics, University of Copenhagen, dr. politMember of the Delors Committee on EMU 1988-89

MY QUICK ANSWER IS YES, BECAUSE

• THE WEAK GOVERNANCE IMPACTS PRIMARILY THREE SMALL PERIPHERAL ECONOMIES;

• THE WEAKNESSES ARE BEING REPAIRED, THOUGH A DIFFICULT TWO-YEAR TRANSITION PERIOD IS AHEAD; AND

• THE INTERNATIONAL MONETARY SYSTEM IS BECOMING MORE MULTIPOLAR WITH THE EURO IN AN ESSENTIAL POSITION

FAILURES OF GOVERNANCE

DID THE ORIGINAL MODEL – CENTRALISATION OFMONETARY POLICY WHILE LEAVING BUDGETARY ANDSTRUCTURAL POLICIES LARGELY TO NATIONAL GOVERNMENTS - BECOME UNWORKABLE , BECUASE IT WAS

• FLAWED FROM THE START, OR• ALLOWED TO DEGENERATE INTO NON-OBSERVANCE?

THE EVIDENCE SUGGESTS THE LATTER, PARTICULARLY SINCE 2003

TWO ARGUMENTS FOR ”LOPSIDED” FRAMEWORK

• POLITICAL FEASIBILITY – EUROPEAN COUNTRIES NOT READY TO CEDE SOVEREIGNTY OVER BUDGETARY OR STRUCTURAL POLICIES

• THE CASE FOR CENTRALISATION MUCH WEAKER FOR THESE POLICIES DUE TO SMALL SPILL-OVER EFFECTS – THEIR IMPACT IS LARGELY NATIONAL

BUT SOME CONSTRAINT ON DIVERGENT NATIONALBUDGETARY POLICIES REMAINS DESIRABLE TO FOSTER LONG-RUN SUSTAINABILITY

THE NEED FOR SUCH CONSTRAINTS DOES NOT JUSTIFY VESTING DISCRETIONARY AUTHORITY IN THE COUNCIL OF FINANCE MINISTERS(ECOFIN)

FISCAL RULES WITH A CEILING ON PUBLIC SECTOR DEFICITS AND A NORM FOR THE PUBLIC DEBT RATIO SHOULD SUFFICE

INDIRECT COORDINATION WAS PREFERRED TO ANY DIRECT COORDINATION OF NATIONAL BUDGETARY POLICIES FOR SHORTER-TERM STABILISATION

STILL THE RULES WERE CRITICISED FOR BEING TOO CONSTRAINING – WHILE THEY WERE IN FACT TOO LAX

MAYBE THE FOUNDERS OF THE EURO WERE TOO PREOCCUPIED WITH PROTECTING THE COMING ECBAGAINST ALL THREATS TO ITS MONETARY PURITY – THE ECB AS ”A MONETARY RULE, NOT A BANK”

• NO AUTHORITY FOR FINANCIAL STABILITY IN THE ECB ?• NO PLAN B FOR THE FAILURE OF THE FISCAL RULES ?

SHOULD A RESIDUAL ROLE FOR FINANCIAL MARKETDISCIPLINE HAVE BEEN DESIGNED ?

CREDIT RISK MUCH LESS IMPORTANT THAN CURRENCY RISK – AND IT TURNED OUT TO BE PERCEIVED AS SMALLER IN THE EURO AREA THAN ANTICIPATED AND SMALLER THAN ON SUBNATIONAL DEBT IN LARGE FEDERAL COUNTRIES UNTIL 2008

HOW CAN ONE EXPLAIN THAT?

• GREAT CONFIDENCE IN THE PERFORMANCEAND PROSPECTS OF PERIPHERAL ECONOMIES, OR

• RELIANCE ON A BAIL OUT OF COUNTRIES, DESPITE THE FORMAL PROHIBITION (ART.125)

ONE OTHER WORRYING TREND – INCREASING DIVERGENCE OF NATIONAL COST AND PRICE TRENDS, ACCENTUATING INTRA-EU COMPETITIVENESS PROBLEMS AND EXTERNALIMBALANCES

THE MEDITERRAINEAN ECONOMIES (NOT IRELAND) ARE RELATIVELY MORE CLOSED AND HAVE TOO MUCH OF THEIR FOREIGN TRADE ÍN COMPETITION WITH LOW-COST PRODUCERS IN THE GLOBAL ECONOMY

IRELAND AND SPAIN HAD EXCESSIVE CONSTRUCTION BOOMS, BOOSTING DOMESTIC INFLATION AND EXTERNAL DEFICITS

THE WEAKNESSES IN GOVERNANCE HAD LARGELY BEEN

ADDRESSED IN 2010, MAKING FUTURE CRISIS LESS LIKELY

• ENHANCED SURVEILLANCE OF BUDGETARY POLICIES WILL BECOME EFFECTIVE DUE TO LESSONS OF 2008-10 AND THE RETURN OF MARKET DISCIPLINE

• SURVEILLANCE ALSO OF OTHER MACROECONOMIC IMBALANCES

• MORE AUTHORITY VESTED IN EUROPEAN FINANCIAL SUPERVISION, BOTH OF INDIVIDUAL INSTITUTIONS AND MARKETS AND MARKETS OF SYSTEMIC RISKS (THROUGH A NEW RISK BOARD, SERVED BY THE ECB)

HOW TO GET OUT OF THE CURRENT CRISIS?

THE MAIN NEW ELEMENT IS THE SET-UP OF A SAFETY NET TO DEAL INITIALLY WITH LIMITATIONS TO THE ACCESS OF SOME BORROWING BORROWING SOVEREIGNS TO FINANCIAL MARKETS, FROM 2013 SOVEREIGNS TO FINANCIAL MARKETS, FROM 2013 ALSO TO DEAL WITH APPROACHING INSOLVENCIESALSO TO DEAL WITH APPROACHING INSOLVENCIES

FROM 2013 ALL BOND ISSUES WILL HAVE FROM 2013 ALL BOND ISSUES WILL HAVE COLLECTIVE ACTION CLAUSES FACILITATING COLLECTIVE ACTION CLAUSES FACILITATING SUBSEQUENT RESTRUCTURING, WITH THE LATTERSUBSEQUENT RESTRUCTURING, WITH THE LATTERCONTINGENT ON STRICT CONDITIONALITY PROGRAMCONTINGENT ON STRICT CONDITIONALITY PROGRAM WITH THE IMF, THE COMMISSION AND THE ECBWITH THE IMF, THE COMMISSION AND THE ECB

WHILE THIS MAY CREATE A ROBUST FRAMEWORK

FROM 2013, PROBLEMS WILL NOT WAIT FOR 2 YEARS

GREEK PUBLIC DEBT WILL PEAK AROUND 160% OF

GDP IN 2012-13, IRISH DEBT AROUND 120%, WHILE

PORTUGAL – NOW NEGOTIATING A PROGRAM – HAS

LOWER DEBT, BUT STRUCTURAL PROBLEMS AS

SEVERE AS GREECE.

SOME ”VOLUNTARY” DEBT RESTRUCTURING MAY

BE ORGANISED OVER THE NEXT TWO YEARS, BUT

THAT MAY NOT BE ADEQUATE

IF NO EXIT – CAN BALL-OUT OR DEBT RESTRUCTURING HELP?

AS EXIT FROM THE EURO AREA IS INCONCEIVABLE FOR A DEBTOR ECONOMY, SOME ACCESS TO ONE OR THE OTHER OFTHE REMAINING TWO DIMENSIONS OF PLAN B – BAIL-OUT AND/OR DEBT RESTRUCTURING HAS TO COME ONTO THE AGENDA BEFORE 2013

BOTH ARE CURRENTLY RESISTED BY THE CREDITORS AND THE POST-2013 SAFETY NET(ESM) IS STILL SUBJECT TO ADOPTION BY PARLIAMENTS IN CRITICAL GUARANTOR COUNTRIES (GERMANY, THE NETHERLANDS, FINLAND) WHICH COULD MAKE ITS USE CUMBERSOME

THE ECB ALSO REJECTS WIDER DEBT RESTRUCTURING FORFEAR OF DESTABILISING MARKETS AND BECAUSE IT WOULDREQUIRE RECAPITALISATION OF THE ECB ITSELF

HOWEVER, REMEMBER THAT

• GREECE, IRELAND AND PORTURAL COMBINED

CONSTITUTE LESS THAN 8% OF EURO AREA GDP, MAKING A SOLUTION ECONOMICALLY MANAGEABLE

• FOR THE INVESTOR THERE REMAINS AN AMPLE SUPPLY OF HIGH-GRADE SOVEREIGN BONDS ISSUED BY THE OTHER 14 COUNTRIES IN THE EURO AREA AND BY THE SAFETY NETS

• DESPITE THE REMAINING ISSUES OF GOVERNANCE, THE QUALITY OF EURO-DENOMINATED BONDS WILL LOOK RELATIVELY REASSURING - COMPARED WITH OTHER INDUSTRIAL COUNTRY DEBT, ALSO DUE TO SLOW-TREND-WISE APPRECIATION OF THE EURO AGAINST THE USD