Roubini Concerns About the Future of the EMU – World Economic Forum, Davos, 2006

Author: Nouriel Roubini  ·  May 5th, 2010  ·  258832http%3A%2F%2Fwww.economonitor.com%2Fnouriel%2F2010%2F05%2F05%2Froubini-concerns-about-the-future-of-the-emu-world-economic-forum-davos-2006%2FRoubini+Concerns+About+the+Future+of+the+EMU+-+World+Economic+Forum%2C+Davos%2C+20062010-05-05+09%3A50%3A29Nouriel+Roubinihttp%3A%2F%2Fwww.economonitor.com%2Fnouriel%2F2010%2F05%2F05%2Froubini-concerns-about-the-future-of-the-emu-world-economic-forum-davos-2006%2F › Share This Print

While in the last few weeks it has become conventional wisdom to worry about the troubles of Greece and other PIIGS and to express concern about the future of the EMU, much of the recent market commentary sounds like Monday morning quarterbacking and worrying about a problem after it has emerged well into the daylight. But, some observers – Marty Feldstein of Harvard, Daniel Gros of CEPS, Martin Wolf of the FT and others like myself – were very early in expressing the concerns about the EMU that have now clearly emerged in the markets.

Specifically, in January 2006 I attended a panel at the World Economic Forum in Davos on the topic of the “Ups and Downs of EMU” (European Monetary Union) where ECB head Trichet, EU Commissioner Almunia, Italian Economy Minister Tremonti, a few other EU officials and myself were supposed to discuss the following questions: Will EMU collapse in the future? Which country will exit first? What will be the consequences of a break-up of EMU? How to avoid that? And what are the prospects for the Growth and Stability Pact?  Unlike the other panelists that ignored the topic and spoke instead about all the good things allegedly associated with EMU, I took the questions seriously by considering some of the problems and risks faced by EMU and the risks of a break-up, especially for the case of Italy. 

My remarks expressing concerns about Italy, Greece, Portugal and Spain, caused a stir with the Italian Minister Tremonti who – in a now famous incident covered by the world press – interrupted me in the middle of my comments and to the consternation of the panel participants shouted out to me: “Go Back to Turkey!!” (I happen to have been born in Istanbul and had started my remarks saying so). 

Here is a verbatim report of my remarks at that famous WEF/Davos panel in January 2006.  There is no Monday morning quarterbacking here.

Remarks of Nouriel Roubini at the World Economic Forum panel on “Ups and Downs of EMU” in Davos in January 2006:

“I have been introduced in this panel as presenting the “transatlantic” perspective on EMU. Actually, as I spent twenty years of my life in Italy and as I was born in Istanbul Turkey that will hopefully be one part a member of the EU my perspective is internationalist rather than transatlantic.

Also, I must clarify that, unlike some transatlantic observers that were always skeptical of EMU – perhaps because of their concerns about the rising economic, political and geostrategic power of a united Europe – I was an early and strong supporter of the idea of a European Monetary Union. My current concerns are that, while EMU has lead to a process of convergence of nominal variables (inflation, interest rates, etc.). it has also been associated with a process of increased divergence in economic performance, especially regarding economic growth rates. This economic performance divergence is a serious problem for some EMU countries (Italy, Portugal, Greece, Spain) and it may eventually lead to a collapse of EMU. I am not supportive of such a collapse but, unless appropriate macro and structural economic policies are undertaken, the risk of a break-up becomes serious.

Before the creation of EMU there was a wide debate on whether the Eurozone was an optimal currency area. The Euro-skeptics made the following points:

1. Monetary unions have to be associated with a full political union as one needs political legitimacy for monetary policies oriented towards price stability and disciplined fiscal policy.
2. There has to be a high degree of business cycle synchronization; local/national specific shocks to output or growth need to be limited.
3. There has to be a high degree of labor market flexibility – both in terms of real wages and labor mobility – to deal with real shocks.
4. The EU lacks the fiscal federalisms of the US where regional shocks to output/GDP have less effects on incomes/GDP because of the effects of federal tax, transfers and government spending.
5. There is the need for more economic flexibility and structural reforms to substitute for the lack of independent macro policies.

The EMU-skeptics concerns were dismissed by supporters of EMU based on the following arguments:

1. Trade integration within the Eurozone had already lead to greater output/growth synchronization and EMU would lead to further trade integration and real synchronization.
2. Because of structural rigidities,  monetary policy is ineffective in affecting output and growth both in the long run and the short run; i.e. the Philips curve is vertical both in the short and long run.
3. Lack of independent monetary, fiscal and exchange rate policy would lead to faster structural reforms that would lead to greater real convergence.

The reality has turned out to be somewhat different as structural reforms have occurred in most member countries but at a pace that is less than optimal, way too slow. Also, the lack of macro policy flexibility has made reforms politically harder. Indeed the costs of reforms in terms of sacrifices are all in the short run while the benefits in the long run; and reform may have adverse demand effects in the short run as they may lead to precautionary savings. Thus, macro stimulus is necessary to facilitate politically difficult structural reforms. The lack of these macro policy tools has thus been an hindrance to reforms in some of the Eurozone countries.

The problem with EMU is that the growth performance of the Eurozone has been dismal in the last few years. The average growth rate in 2001-2005 has been about 1%. Is this slow growth all structural? The answer is no as structural rigidities and slower population growth imply that Eurozone potential growth is probably closer to 2% than the 3.5 of the US. So, the gap between the potential 2% and the actual 1% must be due to macro policies. The US reacted to the 2001 recession by slashing short rates from  6.5% to 1%, turning a large 2.5% of GDP fiscal surplus in to a 3.5% deficit and by letting the US dollar to sharply fall between 2002 and 2004. While US easing may have been excessive and reckless in the case of fiscal policy, the reaction of the Eurozone was too timid; the ECB – excessively concerned about inflation reduced rate much more slowly and less – down to 2% – than the Fed. Fiscal policy changed only marginally and the Euro sharply appreciated until early 2005. So, tight macro policies contributed to the shallow recovery of the Eurozone from the 2001 recession.

More ominously for EMU, there is a growing divergence of economic performance and growth rates within the Eurozone. The ECB argues – based on its research -that there is not growth divergence as:

1. The standard deviation of the growth rates within the Eurozone has not increased after EMU was formed.
2. The dispersion of growth rates within EMU is similar to that of the 50 states within the US.

These statistics are misleading for several reasons:

1. The average Eurozone growth rate has fallen since 2001; therefore the dispersion (standard deviation) of growth rates around this lower mean will be lower.  One should look at the coefficient of variation (the standard deviation divided by the mean growth rate) to get a correct measure of dispersion. And the latter measure show increased divergence.
2. The standard deviation between 1999 and 2005 is stable because the 3 largest Eurozone economies (Germany, Italy, France) have underperformed and moved together. So, low dispersion is driven by a mediocre growth of the largest economies; the divergence between these laggards and the rest of the Eurozone has increased.
3. US states are very different from EU nations in two crucial dimensions; first, if there is a regional recession in Texas, folks pack and move to states with higher growth and employment, i.e. there is larger labor mobility in the US than in the Eurozone. Second, fiscal federalism (the automatic and policy induced change in taxes, spending and transfers) implies that a dollar fall in output in a US state in a regional recession leads only to a 60 cents reduction in actual income. So in the US state GNPs diverge much less than GDPs. This is not the case in Europe where EU wide spending and taxed are minimal.

In summary, there is serious growth divergence in the Eurozone area. This performance divergence is leading to serious tensions in fiscal and monetary policy. Given the growth slowdown and the political difficulties of fiscal adjustment when growth is mediocre, larger fiscal deficit are emerging in many laggard countries. These persistent violations of the GSP are a medium term threat to EM and to the ECB no bailout rule. Also, economic divergence and the tensions it is creating is leading to political pressures on the ECB to do more to stimulate growth, as the reaction of EU finance ministers to the ECB December 2005 decision to hike rates by 25bps shows.

This growth divergence is becoming a serious threat to EMU. As an increasing number of European observers are suggesting, different countries are coping differently to these challenges. Daniel Gros has shown that Germany has reacted with corporate restructuring, cutting labor costs and “competitive deflation”. I would argue that Italy has done little and is experiencing “stagdeflation”, a combination of stagnation and deflation. Indeed, as shown by Daniel Gros Italian labor costs have increased by 20% relative to those of Germany since EMU while Italy’s trade market shares have fallen by 20% relative to Germany. Similar competitiveness problems are faced by Greece, Portugal and Spain.

Gros correctly also points out that the divergence in GDP growth rates has been lessened by the housing bubbles in countries like Italy, France, Spain, Portugal and Greece as low short rates and low long rates (driven by a global bond market conundrum) have caused unsustainable asset bubbles. The current loss of competitiveness of Spain is hidden by the housing bubble but, once this bubble burst, these problems will seriously emerge.

And unfortunately, the lack of serious economic reforms in Italy implies that there is a growing risk that Italy may end up like Argentina. This is not a foregone conclusion but, if Italy does not reform, an exit from EMU within 5 years is not totally unlikely. Indeed, like Argentina, Italy faces a growing competitiveness loss given an increasingly overvalued currency and the risk of falling exports and growing current account deficit. The growth slowdown will make the public deficit and debt worse and potentially unsustainable over time. And if a devaluation cannot be used to reduce real wages, the real exchange rate overvaluation will be undone via a slow and painful process of wage and price deflation. But such deflation will keep real rates high and exacerbate the growth and fiscal crisis. Without necessary reforms, eventually this vicious circle of stagdeflation would force Italy to exit EMU, return to the Lira and default on its Euro debts. Some argue that Italy or other EMU laggards would not exit EMU because a  sharp devaluation of the new Lira  – needed to regain the lost competitiveness – would make the real value Euro debt much higher and unsustainable for the  government, the private sector and households. But look at what happened to Argentina: it devalued and given the balance sheet effects of the depreciation on their US debts it was forced to pesify its dollar debts. Similarly, Italy would be forced to liralize its Euro debts. If Italy were to exit EMU this effective default on domestic and external – public and private – Euro debt obligation would become unavoidable. And a sovereign nation is able to follow such policies – EMU exit, return to national currency and effective default on Euro debt – regardless of any legal or formal constraints that the EMU treaty imposes in terms of no exit clauses. This is not science fiction as Argentina was forced to do the same.

What would be the systemic effect of such Italian exit from EMU? They would be extremely severe on EU capital markets as Italy would default on some of its external debt – the part of its Euro debts held by non-residents. The contagion effects to other EU capital markets and banks would be severe.  And the no bailout rule of the ECB would become effectively threatened as the ECB would be forced to monetize both liquidity and solvency induced runs to avoid a systemic effect on EU financial markets.

In conclusion, my view is that EMU can work and has worked for the Eurozone countries that have reformed and are reforming.  But, unless Italy and other Eurozone laggards change their policies to pursue serious economic reforms that restore competitiveness and growth, they will eventually be forced to exit EMU. This would be a disaster but a disaster that may become unavoidable unless policies change. And I am currently pessimistic about the chances that such changes may occur given the policy makers and policies currently in place in countries like Italy.”