Eurozone crisis and policy failure (Cádiz)

Eurozone crisis and policyfailure

Dr. Steffen Minter

Albert-Ludwigs-Universität Freiburg im Breisgau

March 2016

Schedule for today

1. Stylized facts on Eurozone crisis

2. Eurozone as optimum currency area

(Policy failure Nr. 1 ?)

3. Fiscal policy at the lower (interest rate) bound

(Policy failure Nr. 2 ?)

23.02.2016 Eurozone crises and policy failure 2

23.02.2016 Eurozone crisis and policy failure 3

Part I:

Stylized facts on Eurozone crisis

The Eurocrisis and…rebounding growth?


-8%

-6%

-4%

-2%

0%

2%

4%

6%

2007 2008 2009 2010 2011 2012 2013 2014

GDP growth rates

Euro area (18 countries) Germany Spain Italy

Different view: absolute levels


20.000

22.000

24.000

26.000

28.000

30.000

32.000

34.000

36.000

38.000

2007 2008 2009 2010 2011 2012 2013 2014

GDP per capita

Euro area (18 countries) Germany (until 1990 former territory of the FRG) Spain Italy

Large deviations from expected growth


Recovery in perspective I


Recovery in perspective II


Unemployment: Great depression vs. Eurocrisis

Summary part I

Since 2013: EU economies are gaining

momentum

However, different picture when considering:

o levels instead of rates of change,

o deviation from projected growth path before

crisis,

o comparison to great depression from 1930s.

Large asymmetries between southern and

northern EU member countries



Part II:

Eurozone as optimum currency area ?

Eurozone an optimum currency area?

Benefits from having common currency: reduced

transactions costs (no exchange fees, no currency

risk, etc.)

Costs of common currency: no flexibility in adjusting

nominal exchange rates

Reminder: International competitveness of a country is

highly affected by its real exchange rate

(= nominal exchange rate x relative price level)


Asymmetric shock and single currency in a

stylized model


Real

exchange

rate in A

Output gap

AS

AD

Real

exchange

rate in B

Output gap

AS

AD

Country B (Germany)Country A (Spain)

Before 2007

0 0

Asymmetric shock and single currency in a

stylized model


Real

exchange

rate in A

Output gap

AS

AD

AD´

Real

exchange

rate in B

Output gap

AS

AD

Country B (Germany)Country A (Spain)

After 2007

A

B

C

Contraction with flexible

nominal rates

Contraction without flexible

nominal rates

Asymmetric shock and the Euro

Absence of national currency prevents possibility to

depreciate nominal exchange rate and gain

international competitiveness

Instead: domestic price level decreases

But: this happens slowly and painfully (wage

reductions, shortening of social benefits, etc.)

Several factors that alleviate negative

consequences: labor mobility, fiscal transfers, trade

integration


Summary part II

Euro reduces ability of countries to react to

asymmetric shocks

Negative consequences of economic crises are

prolonged

Alleviating factors are (still) underdeveloped in the

EU (contrary to the US)


From an economic point of view: Euro seems to

be a terrible idea so far

Of course: Political motives have probably dominated

the decision to introduce the Euro


Part III:

Fiscal policy at the lower (interest rate) bound

Hitting rock bottom…


A quick refresher on macroeconomics

IS-LM Model: close relationship between interest

rate and production level:

o the lower the interest rate, the higher the

production (capital becomes cheaper, which

leads to more investments, which leads to more

consumption)

Interest rates are affected by monetary policy (first

policy option)

Once the lower bound has been hit, (conventional)

monetary policy becomes ineffective


IS-LM Model with lower bound


Production Y

Inte

res

t ra

te i

Austerity and the Troika

Second policy option: fiscal policy

Large fiscal deficits: Troika has called for austerity

policy in southern EU countries: cuts in government

spending + tax hikes

According to classic IS-LM: Austerity is contractionary

(IS curve goes to the left)

Motive of Troika: Austerity leads to an increase in

(investor) confidence (IS curve to the right)



Austerity and Confidence

Production Y

Inte

res

t ra

te i

Fiscal tightening and GDP 2007-2015


Summary part III

Monetary policy has lost effectiveness due to the

zero lower bound

Fiscal tightening has been prescribed by the Troika

o prediction of classic IS-LM: further contractionary

effects

o But: eventually stimulating effects through

increased confidence


Result has to be determined empirically: At the

moment little indication of confidence boosting

effects

Conclusion

Eurozone crisis: severe effects and very slow recovery

in southern EU member states

Euro has been bad idea according to OCA-Theory (but:

political objectives might dominate)

Effectiveness of monetary policy restricted due to lower

bound

Prescription of tight fiscal policy (Austerity) rests on

confidence arguments, which are highly controversial


Economy & Finance

Eurozone crisis and policy failure (Cádiz)