As a monetary union, the euro zone seemed to be working very fine for several years. Remember that it came to effect on January 1st of 1999. In this segment, I would like to share with you some thoughts as to what went wrong. Because as you all very well know, over the last six or seven years, Europe, in general and the euro zone countries in particular have gone through a very, very difficult crisis. Let's first take a look at the consequences or the implications of the adoption of a single currency. Here we have a chart in which what we see is how much governments pay for issuing debt, in other words when government want to borrow, they sell bonds. What interest rate do they have to pay in order for investors to purchase those bonds? What we can see over here is that prior to the introduction of the euro in 1999, the different European countries were paying different interest rates on their bonds. Well, it was always safer for investors to purchase a German bond, than it was to purchase a Greek bond. Vertically here what we're measuring is the spread, that is to say the difference between the interest rate that a government, such as the Greek government, has to pay in order to sell a bond. Compared to what the German government has to pay. So all of these numbers are relative to what the Germans have to pay. And as we can see, a country such as Greece, prior to the introduction of the euro, had to pay several basis points, right, more than the German government to borrow. Well the reason was very simple, it was riskier to lend money to the Greek governments. However, as we can see on this chart with the introduction of the euro at the beginning of 1999 the spreads the differences between interest rates start to drop dramatic. And within a few months or a few years of the introduction of the euro there's so much convergence that from the point of view of investors it became almost equivalent to lend money to the German government or to lend money to the Portuguese, or the Spanish, or the Italian, or the Greek government. In other words the interest rates converged. So as I told you earlier for the first few years of the 21st century the markets, investors, were assuming that the euro was a great idea. And then see what happened, beginning in 2007, 2008, the markets, that is, investors, start having doubts about whether it was in fact the same to lend money to the Greek governments or to the German governments. As we can see, the markets reacted in such a way that the spreads, the differences in interest rates, became much bigger than before the introduction of the euro. As you can imagine, this is a situation that is very difficult to manage. Because all of these countries in the euro zone, the 19 of them have the same rules, have the same monetary policy. But if the markets or investors believe that the situation is very different especially when it comes to government borrowing then it become's very difficult to run the euro zone as a monetary union, as a monolithic, as a homogeneous entity. Now we all know what will happened subsequently. Europe went into recession, more importantly, it went into a double dip recession. As you can see over here on this chart, we're measuring GDP growth rates vertically. But over time, we see that the European economies were growing between the years 2000 and roughly speaking, 2007 or so. But by the year 2008 and 2009, in part because of the global economic crisis that started in the United States in the year 2008, the European economies start to enter negative territory when it came to GDP growth. That was the first dip, the US economy, if you remember, avoided a second dip. Because the Federal Reserve intervened very forcefully to rescue banks and also to purchase government bonds and other types of securities to prop up the economy. But in Europe, the European Central Bank didn't do that, so the European economies recovered a little bit in 2011, 2012. Only to fall into recession for a second time, that's the double dip. And of course you can imagine that, that is very damaging to employment. That is very damaging to consumer expectations, that's a situation that is very difficult to manage. As you can imagine, a double dip in any economy is a disaster, because it essentially make it very difficult for consumers, for companies, for investors to recover. As a result, unemployment which had been coming down even in the southern European countries increased to double digit rates after 2010. In countries such as Greece and Spain unemployment was over 20% or even 25% at some point and among young people it went above 50%. I am in Trieste, Italy, this used to be the most important harbor of the Austrian Hungarian Empire. But at the end of World War I it went back Italy and the Italian economy as you know has been going through some difficult times recently. Up until 1999 the introduction of the euro Italy was actually very competitive likened to Germany, machine fuels, automobiles, clothing and textiles, all sorts of manufacturing goods. But over the last 10 years or 12 years, the Italian economy has lost lot of ground. And together with Spain, it's one of the two large economies in the euro zone that is having trouble keeping up with its government debts. Now, Italy's case is different, because Italy's debt, national debt, sovereign debt is mostly in the hands of Italian households. But still, the markets are penalizing Italy for its excessive borrowing over the last decade. And it remains to be seen whether Italy and Spain actually manage to survive the crisis. As you know, in the summer 2012 the European Central Bank initiated a program to buy Italian and Spanish bonds in the open market as a way to support the two ailing economies. Today it's May 15th, 2013 and the clouds of uncertainty are still overcast all over Italy. This is Madrid, Spain, in the background. The economy has been shrinking for the last three years. The crisis was provoked by a real estate bubble that reeled up during the last 12 years. Prices in Spain since the end of 2007 for real estate have gone down by about 26%. That's not that much when you think that in Ireland they went down by 50%. And that economists estimate that real estate prices in Spain are still about 15% overvalued relative to personal purchasing power. In Germany in the meantime, over the last five years, real estate prices have gone up by 10%. But they're still undervalued, and that's because Germany didn't have a real estate bubble. The situation in Spain is actually pretty dire. The economy in 2013 is expected to shrink at a rate of about 2%, minus 2%, that is and unemployment is already 27%. Nearly half of all young people are unemployed in Spain. So let's take one step back. Why did this happen in Europe? And why didn't it happen in a place like the United States, although both parts of the world were heavily affected by the global financial crisis. Well, let's try to understand the consequences of monetary unions. First of all, a very important consequence of any monetary union is that each of the countries that participate in it can no longer print their own money in order to pay down their government debt. You see, this is what, typically, governments do. They borrow too much. And then when they're in trouble, what they do is they print money, they print cash in order to retire some of that debt. That is called inflating your debt away. And it's called inflating your debt away because it obviously produces inflation. But sometimes, governments need to do that because they have no other choice. Needless to say, if Portugal, Spain, Italy, Ireland, or Greece accumulated too much debt during the Euro era, they could not print currency because they no longer had their own currency. Now they have the Euro as their currency. And that currency was controlled by the European Central Bank. That's the first implication or consequence of monetary union. In other words, the governments lose one option, one alternative for dealing high levels of debt. The second consequence is as important as the first, which is that they can no longer devalue their currency In order to regain competitiveness. Normally, what weaker economies such as those in southern Europe typically do is every five years or every eight years they devalue their currency. They do something so that their currency loses value in the markets relative to other currencies so that their exports remain competitive. Let's say they orchestrate a devaluation of 5% or 8%, or in some cases, even 10%. All of these countries in southern Europe used to do that every five or eight years. And that's what kept them competitive in the global marketplace. But after the introduction of the Euro in 1999, these governments didn't have that option at their disposal because they didn't have their own currency. So as you can see, governments that decide to participate in a monetary union are constrained. They are in a straitjacket. They cannot do what used to be able to do when they had their own currency regarding paying down their debt or increasing their competitiveness by devaluing their currency. But here's the catch. In order for a monetary union as large and complex as the European one to work, then you would need to have three other pieces in place so that it could work. The first one is that labor, people should be able and willing to move around the eurozone in search for the best opportunities in terms of jobs. If they are unwilling or unable to move, then you are more likely to get very high rates of unemployment in some countries and much lower ones in others, as we saw in a previous chart. And the problem with that is that then you're forcing the central bank, in this case, the European Central Bank to make monetary policy for the average country knowing that those with very high unemployment are going to suffer. And so will also those other countries that have very low unemployment because a monetary policy can only be one single policy for all countries, regardless of their unemployment rate. Remember, of course, that when unemployment is very high, you want to lower rates, so that then there would be an incentive for investment and an incentive for economic growth. And when unemployment is very low, and the economy is overheating, then you would prefer to perhaps increase rates a little bit to avoid inflation. So again, when in the same monetary union in Europe, by the year 2010 or 2011, you have countries with more than 20% unemployment like Greece or Spain. And at the same time you had countries like the Netherlands or Germany with unemployment rates of less than 6%. It made it very difficult for the central bank to implement a single monetary policy regarding, for example, interest rates. The second issue is the lack of a fiscal union. You see, the European countries put together the eurozone so quickly in response to German unification, as a political bargain, that they didn't have the time to think about something very important, which is that a currency normally has a treasury behind it. The Dollar, the US Dollar has the US Treasury behind it. In Europe, however, what we have is a single currency, the Euro. And then you have 19 different treasuries collecting taxes and spending that revenue for each of the 19 member countries of the eurozone. Why is this a problem? Well, it's a problem because, as you know, when the business cycle makes a turn for the worse, the economy is entering a recession. Then what governments typically do is they use fiscal policy to try to buffer the decline in the economy and to try to encourage investment and growth. Well, when you have 19 different treasuries, each of them facing different situations on the ground in the 19 member countries of the eurozone, that task becomes very important. And, of course, you cannot coordinate fiscal policy with monetary policy because monetary policy is being driven by decisions at the central level, at the European Central Bank. And then the third missing piece in the eurozone that made the crisis so much more difficult to tackle was the lack of a banking union. Why is a banking union important? Well, a banking union is important because what it means is that you will have a single authority supervising banks. That is, watching the banks to see if they are overlending, or they are engaging in practices that might be too risky. A banking union will also include a resolution mechanism. That is to say, a system whereby if a bank gets into trouble, you know exactly what procedures to follow to protect the depositors, the people who have put money into the bank, or to protect other stakeholders whose assets might be put at risk because of the bank going bust. And then lastly, the third element of a banking union would be deposit insurance. Here in the United States, it's called the Federal Deposit Insurance Corporation. So all depositors are covered up to a certain level by this federal guarantee. In Europe, however, the Euro as a currency was introduced in 1999. But each country still manages it's own deposit insurance scheme. This issue of a lack of a bank union became very, very, very important to the resolution of the crisis in Europe for the following reason. Which is that when governments got into trouble because of the high levels of debt, they ask their local banks to buy more government bonds. And essentially what happened, more or less by the year 2013, is that sovereign risk in Europe, that is to say the risk associated with the financial activities of the governments, became the same risk As bank risk, and that is a very dangerous situation when both types of risks are one and the same. Here is the fundamental problem in Europe moving forward. The problem is that Europe is too diverse, it's very heterogeneous. You have economies that perform very well, and you have economies that don't perform that way. But you have in 19 of these countries the same currency as legal tender. The problem of course is that in a union such as that, where in addition to monetary affairs being common to every country, you also have open trade meaning no barriers to trade. Not every country can be thrifty. That's the other issue in Europe. Some countries have very high savings rates, and others have very low savings rates. And not country can be frugal. In other words, if everybody's frugal, everybody tries not to spend. As in the famous austerity measures. Then essentially there's no locomotive, there's no economy that can pull the rest out of recession. I'm going to return to this issue in a moment. At the same time, the third point that I want to make which is really important. When you have a situation in which 60 or 70% of all the trade that occurs in Europe, is with an other member if the European Union or the Euro zone. Then what is very clear is that, not every country in that arrangement can have a surplus. So in some countries like Germany, or the Netherlands, or Austria have very large trade surpluses in that situation. Then that means that other countries in that same trade bloc must have very large deficits, unless of course countries in the trade bloc straight a lot with the rest of the world. But that's not the case in Europe, as I mentioned just a moment ago. Most of Germany's trade and most of Germany's surplus in trade, has to do with the rest of the European Union. Germany generates only about a third of it's surpluses. From trade with US, with Asia, with Africa, with Middle East or in Latin America. And beyond economics and beyond financial aspects, I also want to bring to you another aspect of European diversity that's more cultural in nature. Which is the different altitudes that Europeans from different countries have. Regarding savings, and regarding the futch, and let me capture this with a word. There's a word in the German language, "Die Schuld". That means two things, it has two connotations, two meanings. One is debt, and the other one is guilt. So the Germans use the same word for both debt and guilt. So do the Dutch. I can assure you since I'm from Spain, that in Southern Europe, we have very different words for the concept of debt and the concept of guilt. In other words, in Germany, when somebody is deeply into debt you supposed to feel guilty about it. I can assure you that in Southern Europe, most people think that borrowing enormous amount of money is actually the smartest thing you could do. But there's also an economic reason for this that goes beyond culture. You see Southern Europe has always had high inflation and as you know the Germans, are not very inclined to have high inflation given their experience in the 1920s. When there's high inflation, when those people who are in debt benefit because as you know, they need to return the money if they ever do in the future. But they will do so with devalued currency, given that there is high inflation. So I really want to emphasize this. In addition to all of the political, the economic, the financial differences in Europe, we also have deeply ingrained long-standing cultural differences, that translate into different economic attitudes and behaviors. And this is yet another reason why it was very difficult to introduce a single currency in Europe. Because once again, people have very different world views about money, and about investing, and about saving. Let me show you two charts to document some of the facts that I've been telling you about. Both of them have to do with Germany. On the left, we see the German surpluses in trade in goods, that is the same merchandise. Now, as you can see, nearly half or in some years, more than half of those surpluses have to do with the European Union and/or the Euro Zone. And on the right, we have a broader indicator or measure of trade surpluses which is a current account. It also includes services and transfers. And as you can also see on this chart over the years, Germany has generated a very large proportion of its surpluses from the rest of Europe. I show you these charts to emphasize the point, that while it is true that the German economy is very competitive, it is equally true to say that the German economy does well, because it does better than the other European economies, which is where they sell most of their goods and services. So in other words, the rest of Europe may need Germany, but it's equally accurate to say that Germany needs the rest of Europe. So, what should be done in Europe? We know that after many years of crisis the economy is still not vibrant, it's not growing as much as it would need to grow in order to reduce unemployment, especially in southern Europe. Where normally the analysis of the situation we focus on the issue of sovereign debt, government debts, or on the state of the banks. How solid are they? I would like to bring to your attention a different set of dynamics, which I think are fundamentally important to the situation here. I would like to tell you about labor mobility in Europe, about labor unit costs and about unemployment. Let's first take a look at labor mobility. You see here in the United States, people move around very often. Statistics show that about 2.3% of the US population, moves from one state to another in any given year. 2.3%, that's actually a very high percentage of people who move from one state to another within the United States. The corresponding figure for the European Union with 15 members in Western Europe, so excluding the Eastern European countries Is about 0.2%. So you can see, the rate of labor mobility in Europe is about 1/10 where that rate is in the United States. Now, listen to this. If we exclude Luxembourg, then that annual rate of labor mobility in Europe drops to 0.1 percent. Now, you may be wondering what if people are commuting, let's say from Luxembourg to France, or from Belgium to the Netherlands. Given the distances in Europe, are oftentimes much shorter than here in the United States. Well, if you include commuting, then the rate only grows to about 0.6%. Still much lower than the one in the United States, which is 2.3% remember. And then you might be wondering, well, you're considering countries in Europe. But you're considering states within the United States. What if we considered inter-regional labor mobility in Europe counting mobility within regions within countries in Europe? Well in that case the rate will go up to 1.0% still much lower than the 2.3% in the United States. Why is this important? Well this is important because as you know here in the United States people move all the way from Ohio to Texas if they believe that they will have better job market opportunities in Texas. And a lot of people do that. Well, that's not happening in Europe. Technically speaking people can freely move in Europe and set up a residence in any other member of the European Union. But in practice it doesn't happen as often. Mainly because there are major language barriers in the United States. We all speak English. In Europe of course, if you want to move to Swedish in search of a job, it may be a good idea for you to learn Swedish and that imposes a big cost. So, a lot of people are discouraged from crossing borders. The second thing that I want to bring to your attention, which is very important, is that some European economies, over the last 20 years or so. And especially since the introduction of the Euro, have been much more effective at keeping labor costs under control. On this chart, we have the evolution of the so called the Unit Labor Cost. In Europe, seems the introduction of the single currency back in 1999, is an index number what we are measuring vertically. So in other words, every country that you see on the chart, starts at the same level in 1999. And then, we are going to see how Unit Labor Cost evolved until the beginning of a crisis in 2009 and then subsequently. Well, you can see up until the year more or less 2010 is that in Germany in the bottom of the chart, Unit Labor Costs remained flat. So Unit Labor Cost is how much it costs companies. In the form of wages to produce something, and this is calculated for the entire economy. So in other words the definition is how much does it cost in terms of wages to produce one unit of gross domestic product, of GDP. That's what's captured here is aggregate for the entire economy. And as you can see up until the year 2010 the Germans were very disciplined. They barely increased, if at all, their labor costs. So they remained very competitive, not just in the rest of Europe, but in the overall global economy. At the same time in France, and especially in the Southern European countries, and also in Ireland, the situation was very different. Labor costs went through the roof, wages increased, and of course these countries lost competitiveness. By the year 2010, many of these countries had lost 30% or 40% competitiveness. The way to calculate that number is just to look at the scale, the vertical scale on the chart. If a country reaches 130, but Germany stays at 100, that means that country is 30% less competitive than Germany after a few years. If a country reaches 140 on this indicator that means relative to Germany which has stayed roughly speaking at a 100. It means that that country lost 40% competitiveness from this point of view alone, labor costs. Now after the crisis as you can see of course, several of the countries in southern Europe engaged in quite dramatic austerity measures. Asking people to accept lower wages. Especially in the public sector. But also in the private sector. And you can see that in many of those countries, especially in Ireland and Spain, the unit labor costs came down as a way to adjust for the crisis. The only country. If you look carefully at the chart, that didn't go through an adjustment in its labor market to try to reduce wage costs was France. And France, of course, if you remember, didn't have as much difficulty as Italy or Spain or Portugal in terms of funding its budget deficit. So they didn't feel the need to make a big adjustment in their labor market, to try to regain competitiveness and get the economy up and running again. In a moment, I will come back to what happened, especially in Germany after the year 2010. You might be wondering, how come that until more or less that year, the Germans were very disciplined and they barely increased their wage costs. But subsequent to that year, their unit labor costs started to go up.
