Nouriel Roubini foresaw Italian crisis back in 2006

Everybody hates Nouriel Roubini just because he happened to be correct about everything. I respect the guy because he saw this crisis coming and described it so well. I am astonished to see that, back in 2006, he correctly foresaw the crisis in Greece and Italy:

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) 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:

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.

There has to be a high degree of business cycle synchronization; local/national specific shocks to output or growth need to be limited.

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.

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.

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:

Trade integration within the Eurozone had already lead to greater output/growth synchronization and EMU would lead to further trade integration and real synchronization.

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.

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:

The standard deviation of the growth rates within the Eurozone has not increased after EMU was formed.
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:

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.
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.

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.

…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.