EUROPE AND THE WORLD ECONOMY

Michel Aglietta Univ. Paris Nanterre and Cepii

Dual crisis and deteriorating macro conditions in Eurozone

Sovereign and banking crisis have deteriorated since May 2012:
Sovereign bond spreads in Spain and Italy The European banking system is retreating on national lines: pressure to deleverage (IMF: > 2trns over next 2 years). Cross-border interbank liabilities shrinking renewed threat of credit crunch Leakage of deposits from Spanish banks since March ~ -2% m-o-m

Retrenchment in credit markets spread to every leveraged agents spending in the private sector in debt-ridden countries:
3 consecutive quarters recession in Italy: unemployment and purchasing power consumption -2.4% and GDP -1.3% end Q1. Risk of -2% recession and more in 2012 Spain: real estate prices + credit crunch + export slowdown -3 to -4%GDP growth in H2 2012 (y-o-y) The worsening recession in Southern Europe cum much reduced steam in world trade drag down the whole Eurozone

Feedback on financial crisis: fiscal deficit/GDP will not fulfill commitments and Sovereign debt/GDP will rise 15 to 20% before end 2013

Structural deficiencies and weak governance threaten the very existence of the Euro
The Euro is an incomplete currency:
Fiat money without political sovereign gold standard without exit foreign currency with fixed exchange rate for member countries no LOLR for public debts Single financial market explosion of private debt in countries where interest rates decline more after EMU entry divergence in competitiveness

The fragmentation of the financial system on national lines cannot support a single currency:
Latin Union stopped being operational in 1879 after the demonetization of silver Gold Standard unraveled after 1931 with huge disparities in competitiveness, withdrawal of international lending and lack of cooperation among governments

Threat of a deadly scenario:

Obstacles in sharing sovereignty muddling through the usual way of emergency measures fuzzy recovery return of stress in financial markets intensified fragmentation worsening recession waves of bank and sovereign bankruptcies This is the Japanese deflationary syndrome. But an heterogeneous bundle of countries cannot stand such an outcome without splitting
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The ineffective response to the crisis

Deleveraging has hardly started in Europe

Impact of the lack of a complete currency

Euro Zone & United States : 10 year rates

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2 juil.-08 janv.-09 juil.-09 janv.-10 juil.-10 janv.-11 juil.-11 Euro Zone: Composite rate United States
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Losing momentum in the world economy

US: growth potential might have abated from 3 to 2% + concern of fiscal cliff
For the last 3 years early burst of growth has petered out in late spring and job creation has mitigated because output gap is much lower than estimated with pre-crisis trend Fiscal cliff: 5% GDP automatic tax increase + spending cuts if political stalemate persists at yearend Protracted undervalued Stock market reveals high uncertainty and prolonged operation twist to keep long rate as low as possible

India: substantial growth slowdown (9.2%5.3%) and persistent disequilibria:

Public finance deficit (-5.9%), current account (-3.5%) and inflation (7.2%) Large industry subsidies and widespread corruption vested interests + no more political constituency for structural reforms

Losing momentum in the world economy (2)

China: growth decelerating to 8.1% (y-o-y) in march 2012 from 8.9% Q4 2011
Still above the min target (7.5%) no need for large stimulating plan but flexibility Speedy response of the State Council: more accommodating monetary policy + facilitating credit to SMEs + approval of investment projects + subsidies to encourage purchase of energy-saving household appliances The policy measures are consistent with 5-year plan to transform the growth pattern: more government spending on health, education and social security, removing barriers to services, environment-friendly urbanization.

Brazil: rate of productive investment persistently too low to support >5% growth
Cost of capital far too high for too long with SELIC>10% Policy mix dedicated to drive real interest rates down: restrictive fiscal policy (3% target primary surplus) to give room to monetary policy whose objective is to go on lowering SELIC (350bp in one year to 9%mid-2012) Links with China + better macro stability aims at reaccelerating growth to 3.3% (2.7% in 2011)
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Investigating world macro interdependencies

Transmission of shocks from developed to emerging market economies:
Indentifying channels of transmission and measuring macro spillovers among regions in using an econometric Bayesian structural VAR model developed in Cepii The model is stochastic and recursive. Macro interdependencies between 2 developed economies (US and Euro zone) and 3 groups of emerging economies (China, rest of emerging Asia and Latin America) Interdependencies described with GDP growth rates, global liquidity (proxy 3-month treasury bill rate) and global financial risk perception (proxy VIX indicator)

Output elasticities of external demand shock:

China U.S. GDP Growth Eurozone GDP Growth China GDP Growth Emerging Asia GDP Growth 1Q 0.54 0.22 3Q 0.23 0.31 Emerging Asia 1Q 3Q 1.02 1.11 0.06 0.75 0.53 0.81 Emerging Latin America 1Q 3Q 1.28 1.64 0.25 0.25 0.70 0.78 0.24 0.43

Stress scenarios in the world economy

Simulating scenarios of Euro zone partial disintegration: -3% recession lasting 2 years. 2 Variants depending on Us response: preserving 1.5% growth/ growth falling to 0
Emerging countries China Other emerging Asia Latin America Initial growth 8.8 3.2 2.8 EZ (-3%) and US (+1,5%) 2Q 7.8 1.4 2.0 2Y 7.4 2.2 3.3 EZ (-3%) and US (0%) 2Q 7.0 0.4 0.4 2Y 8.2 3.0 2.9

What do the simulations teach on the channels of interdependence?

Latin America much more dependent on the US Crucial importance of prices of primary commodities for Chinas adjustment: the larger their reduction, the stronger rebound via real income and domestic demand China is an important intermediary channel for the profile of adjustment in other emerging market countries
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Saving the euro: ECB mandate for financial stability

ECB mandate out of touch of reality:
One objective, one instrument: financial stability price stability multiple
instruments in controlling credit-induced asset price dynamic

one size fits all: real and financial divergence basic cause of crisis. Multiple instruments tailored to financial need of distressed countries

Saving the euro depends crucially on capping interest rates on sovereign debts to sustainable levels connected with objectives of fiscal union
Either ECB intervenes directly in sovereign markets or EFSF/ESM do the job with bank license Reasonable cap interest rate must be determined by long-run sustainability condition: time span for adjustment compatible with historical experience (10 to 15 years), sustainable primary surplus<3% GDP . The cap must be the lower, the lower the attainable cyclically-adjusted growth rate The cap is differentiated between countries according to the constraints of fiscal adjustment. Going a step further in resolution leads to Eurobond issuance
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Saving the euro: issuing Eurobonds

An instrument in fostering convergence and resolution of the Euro crisis if they help counter 4 destructive processes:
Negative feedback loop between banks and sovereigns Excessive public indebtedness Crisis of confidence in political resolve Growth predicament

Conditions 1 and 3 depend on how they are issued: joint guarantee with an insurance mechanism to eschew moral hazard, enhancing devices to achieve the quality of the high-grade bonds. They address condition 2 indirectly only if coupled with cooperative fiscal mechanisms leading to sustainable debt profiles. Condition 4 is linked to European growth policy with creation of a European Investment and reconstruction Fund issuing Eurobonds for institutional investors What type of Eurobonds for addressing conditions 1 and 3?
Progressive conversion of national debt on the flows of rollover with an insurance mechanism attached Insurance paid to central insurance Fund by countries that gain most in the conversion according to a formula making the insurance premium a decreasing function I of their progress in fiscal adjustment Enhancing via seniority, pledging collateral (gold and unused SDR), earmarked taxes
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Saving the euro: building a banking union

The ECBS is the natural supervisor for all banks:
ECB supervisor of systematically important institutions National central banks supervisors of secondary banks

A single centralized deposit guarantee scheme to reestablish unity in banking:

A scheme limited to the Euro zone to pool the risk among member States, the deposit guarantee fund being located at the ECB since it is partner in bank supervision A scheme financed by insurance premium levied on banks A centralized fiscal resource to protect the insurance fund against the contingent risk of becoming insolvent

A central mechanism of bank resolution

Eradicating the too-big-to fail syndrome requires bail-in automatic procedures involving unsecured bondholders Prompt corrective action exerted by the supervisor Living wills provided by all systemically important institutions Strong power for the resolution fund (ESM) to restructure banks: selling assets, sacking management, writing down debts, ordering spinoffs and mergers, temporary takeovers and resale
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