The Euro in Crisis

Uri Dadush

Carnegie Endowment for International PeaceChicago, June 14, 2010

Main Points

1. Resource misallocation and competitiveness central

2. Fiscal is most immediate risk

3. EMU poses big constraints

4. …Requiring aggressive use of available policy tools

Inflation and Interest Rates ConvergeAnnual Inflation and Long-term

Government Bond Yields

Source: IMF.

0

5

10

15

20

1980 1985 1990 1995 2000 2005

GIIPS EUN GIIPS EUNBond Yields Inflation

Source: Eurostat.

Total Increase in Prices of Goods and ServicesPercent increase, 1997 – 2007

0

15

30

45

60

Ireland Greece Portugal Spain Italy Germany

ServicesGoods

Prices of Non-tradables rise

Source: Ahrend, Cournède, and Price, “Monetary Policy, Market Excesses and Financial Turmoil,” OECD, 2008.

Divergence of Policy Interest Rates from Taylor Rule

Basis points, 2001 – 2006

Appropriateness of Monetary Policy

-100 0 100 200 300 400 500

Germany

Spain

Greece

Ireland

Competitiveness Loss

* Actual value: - 45

Source: European Commission.

Change in Real Effective Exchange Rate Based on unit labor costs, percent change, 2001 – 2008

-20

-10

0

10

20

30

40

Irelan

dIta

lySp

ain

Greece

France

Portuga

lUK

Austria

German

yUSA

Japan

*

0

3

6

9

12

Ireland Spain Greece Portugal Italy Germany

Governments Grow Rapidly

Source: Eurostat.

Annual Growth of Government ExpenditureCurrent Euros, average percent increase, 1997 – 2007

0 3 6 9 12 15

Austria

Germany

Portugal

Greece

Spain

Ireland

Source: Eurostat.

Increase in Government Deficit

Percent of GDP, 2007 – 2009

Deficits Increase in Crisis

EMU Constraints

• Wide differences in income, economic structure

• Weak equilibrating mechanisms (labor mobility, fiscal transfers, shared financing)

• Rigidities in labor and product markets

• ..but with loss of monetary and exchange rate autonomy…

Use Available Instruments Aggressively

• Restructure Greek debts

• In troubled countries: cut deficit (stabilize debt/GDP in 3 years); recover competitiveness (6% over 3 years).

• Euro zone: maintain low policy interest rates; promote lower Euro; Germany and others adopt expansionary policy (stimulus worth 1% of euro zone GDP).

• IMF, US provide support