Were Europe’s curent problems never imagined?

Actually the current problems in Europe were well thought of in advance. Just that probability assigned to them was small. (Warning: started small but ahs turned into a long post) 

I came across this exciting speech from Krzysztof Rybiński, Deputy President of National Bank of Poland. The speech was given in 2007. The speech details the costs and benefits of Poland joining the EMU. In the costs, the events we are seeing now are foreseen:

What were the benefits:

Let me begin with the benefit side. Economists typically concentrate on three sources of economic benefits related to monetary union. These are:

  • lower transaction costs, (estimated at 0.2% of GDP for Poland, not much but worth saving)
  • lower interest rates, (was estimated that joining ECB could reduce long term interest rates by more than 1%. The impact on investment and consumption depends on assumptions)
  • trade creation (one study showed currency union could boost trade volumes by 200% within members. The figures look exaggerated and some more studies have followed. But yes all show gains above 50% which is quite good)

Now cost side of joining EMU. He says there are 2 costs – asymmetric shock and micro and macro imbalances. At that time both were seen as tail events – low probability of taking place but huge impact if it takes place.

Asymmetric shocks  are shocks that affect only selected member(s) of a monetary union. Such events are considered the biggest threat to unions (Mundell 1961), because joining a common currency area substantially reduces the set of policy tools which could be used to mitigate the impact of the shock. Let us assume that a negative demand shock affects the Polish economy (e.g. consumers decide to buy less goods and services). In the short and medium run this brings about a reduction in output and higher unemployment.

As long as Poland has its own currency, it can use both monetary and fiscal policy to stimulate demand and reduce the impact of the shock on output and employment. Moreover, the exchange rate might adjust (depreciate) and thus make our exports more price-competitive. Once in the eurozone, two of these channels are closed. First, there is no independent domestic monetary policy which could lower interest rates, and one should not expect the ECB to react to a local shock. Second, after joining the eurozone the exchange rate disappears, so there can be no exchange rate adjustments.

Accordingly, the only policy tool left after euro area accession is fiscal policy. For this reason it is of crucial importance to run a balanced budget in the medium run, so that in case of negative shocks, there is room for increasing the deficit and thus buffer the shock.

Now let me move to the possibility of rising micro- and macroeconomic imbalances. Such imbalances can take the form of lending booms, current account deficits or increasing inflation pressure. Such a set of symptoms in a monetary union member country reveals in most cases one common cause – real interest rates that are too low. Economists have for a long time argued that each economy has an appropriate, long-run level of the real interest rate  called the natural rate of interest (Wicksell 1898). Keeping interest rates at this (unfortunately unobserved) level should guarantee that the economy will remain in equilibrium – output will not exceed production capacity and inflation will remain stable (Woodford 2003). This is what implicitly or explicitly most inflation targeting central banks are trying to achieve.

Both these tail events came true. You had micro and macro imbalances which led to high deficits and then the financial shock hit leading to a wide collapse.

And guess what? Why was Poland saved in this crisis? It was because it did not join the EMU/ECB (I don’t know the exact reasons for the same). So it avoided the micro-macro imbalances. As Rybiński says:

One of the problems with joining a common currency area might be that real interest rates in this area will be lower than the natural rate of the new member. Recent research shows that this might be the case for Poland, where the natural rate has remained in the past above the euro area level (Brzoza-Brzezina 2006). For Poland entering the eurozone means lower nominal interest rates (the spread on long-term rates remains between 100 and 150 basis points) and higher inflation (due to the catching up process). Together this means a drop in real interest rates, which could induce people and enterprises to substantially increase borrowing, and spend the loans on consumption and investment goods. What could be the consequences of this?

We know the consequences of all this. Greece, Spain etc all paid the price heavily.

And when the global asymmetric shock hit Poland, it could use both mon pol and exchange rate to get economy back on track. I had pointed that Poland was the only EU country to avert an outright recession.

IMF Survey online: Looking back to the crisis, what were the key factors that enabled Poland to avoid a recession?

Thomsen: First, Poland is a fairly big economy with a large domestic market, which makes it less dependent on exports. During the crisis, this meant it was less exposed to negative spillovers through the trade channel than other countries in central and eastern Europe, for instance Hungary and the Czech Republic.

Second, Poland has a well capitalized and profitable banking system. That also helped mitigate possible contagion through the financial channel.

A third factor is that policymakers had considerable room for countercyclical monetary and fiscal policy, because Poland did not have any severe macroeconomic imbalances on the eve of the crisis.

Finally, the country has clearly been helped by its flexible exchange rate. Overall, the fact that Poland did so well speaks not only to its strong economic fundamentals, but also to good policy management and sound economic policies.

Again what should Poland do now? In 2007, it was felt costs are lower than benefits:

Summing up, I have discussed selected aspects of the cost-benefit analysis of Poland’s adoption of the euro. Although the costs may seem substantial, one has to bear in mind two things. First, the probability that these costs will have to be incurred is relatively low. Second, their magnitude depends crucially on domestic policy – prudent banking sector supervision, labor market reforms and sound fiscal policies to name a few. In my view, given the evidence that reforms have been halted in many countries after entering the eurozone, these measures should be taken before the euro area accession.

 And now:

IMF Survey online: Poland’s flexible exchange rate helped the country adjust during the crisis. How quickly should Poland seek to adopt the euro?

Thomsen: The authorities have never set an official date, although at some stage there was an unofficial target date of 2012. Given the adjustment effort that lies ahead for Poland in the next couple of years, one should not set an early date for ERM II entry.

More generally, in determining when to adopt the euro, policymakers should be mindful of how well their country has been served by the flexible exchange rate policy. That said, there is no doubt that euro adoption remains an important goal for Poland.

So, all these risks were well thought of and well in advance. What were seen as tail risks in EMU came true with both shocks hitting together. I am wondering if analysts put a probability on happening of this crisis like they do for all financial crises – 8, 9 or even more sigma etc?

However, it will be wrong to say Poland was not affected by this crisis because of not joining EMU/ECB. There were other East European economies like Hungary, Latvia, Lithuania etc. which were not part of the EMU but were affected deeply by this crisis. They could use both the options of mon pol easing and currency devaluation but could not prevent the crisis. Poland seems to have had more balanced economic and financial system in place as well. We don’t know whether Poles would have messed up after joining the Euro like other economies. So, basics do matter.

The amazing part of this crisis is that it is global but has effected each economy differently. So, you have a lot of country case studies and interesting analysis to follow.

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26 Responses to “Were Europe’s curent problems never imagined?”

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