Monetary union - wz.uw.edu.pl · Single Currency Evolved European Currency Reform Initiatives, 1969-1978 The Werner report (1969) It set out a blueprint for the stage-by-stage realization

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Monetary union

Jan Michalek

Introduction

European Union countries have progressively narrowed the fluctuations of their currencies against each other.

This culminated in the birth of the euro on January 1, 1999.

We will focus on the following questions:

How and why did Europe set up its single currency?

Will the euro be good for the economies of its members?

What lessons does the European experience carry for other potential EMU members and other currency blocks?

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The Theory of

Optimum Currency Areas

It predicts that fixed exchange rates are most appropriate

for areas closely integrated through international trade

and factor movements.

The conditions of Optimum

Currency Area (OCA)

Criterion 1 (Mundell): Labour mobility In an OCA labour moves easily across national borders

Criterion 2 (Kenen): Production diversification Countries whose production and exports are widely diversified and of

similar structure form an OCA

Indeed, in that case, there are few asymmetric shocks and each of them is likely to be of small concern

Criterion 3 (McKinnon): Openness Countries which are very open to trade and trade heavily with each other

from an OCA

Distinguish between traded and nontraded goods Traded good prices are set worldwide

A small economy is price-taker, so the exchange rate does not affect competitiveness

In the limit, if all goods are traded, domestic good prices must be flexible and the exchange rate does not matter for competitiveness

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The conditions of Optimum

Currency Area (OCA); part 2

Criterion 4: Fiscal transfers Countries that agree to compensate each other for adverse shock form an OCA

Transfers can act as an insurance that mitigates the costs of an asymmetric shock

Transfers exist within national borders Implicitly through the welfare system

Explicitly in federal states

Criterion 5: Homogeneous preferences Countries that share a wide consensus on the way to deal with shocks form an OCA

Matters primarily for symmetric shocks Prevalent when the Kenen criterion is satisfied

May also help for asymmetric shocks Better understanding of partners’ actions

Encourages transfers

Criterion 6: Commonality of destiny Countries that view themselves as sharing a common destiny better accept the costs of

operating an OCA

A common currency will always face occasional asymmetric shocks that result in temporary conflicts of interests This calls for accepting such economic costs in the name of a higher purpose

Economic Integration and the Benefits of a Fixed

Exchange Rate Area: GG Schedule

Monetary efficiency gain

The joiner’s saving from avoiding the uncertainty, confusion,

and calculation and transaction costs that arise when

exchange rates float.

It is higher, the higher the degree of economic integration

between the joining country and the fixed exchange rate area.

GG schedule

It shows how the potential gain of a country from joining the

euro zone depends on its trading link with that region.

It slopes upward.

The Theory of


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The Theory of


Figure 20-4: The GG Schedule

Degree of economic integration between the

joining country and the exchange rate area

Monetary efficiency

gain for the joining country GG

Economic Integration and the Costs of a Fixed Exchange Rate Area: The LL Schedule

Economic stability loss

The economic stability loss that arises because a country that joins an exchange rate area gives up its ability to use the exchange rate and monetary policy for the purpose of stabilizing output and employment.

It is lower, the higher the degree of economic integration between a country and the fixed exchange rate area that it joins.

LL schedule

It shows the relationship of the country’s economic stability loss from joining.

It slopes downward.

The Theory of


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The Theory of


Figure 20-5: The LL Schedule

Degree of economic integration between the

joining country and the exchange rate area

Economic stability

loss for the joining country

LL

Costs of monetary union-

keynesian approach

PEMUPH0 PP0PH

PP

W/H

W/P WP

WH

UP

UH

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The Decision to Join a Currency Area: Putting the

GG and LL Schedules Together

The intersection of GG and LL

Determines a critical level of economic integration between

a fixed exchange rate area and a country

Shows how a country should decide whether to fix its

currency’s exchange rate against the euro

The Theory of


The Theory of


Figure 20-6: Deciding When to Peg the Exchange Rate

Degree of economic integration

between the joining country and

the exchange rate area

Gains and losses

for the joining country

LL

GG

Gains exceed

losses Losses exceed

gains

1

1

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Comparison of costs &

benefits

LL

GG

T*

Gains &

losses

Trade (% GDP)

LL

GG

T*

Gains &

losses

Trade (% GDP)

Monetaristic approach Keynesian approach

The GG-LL framework can be used to examine

how changes in a country’s economic

environment affect its willingness to peg its

currency to an outside currency area.

Figure 20-7 illustrates an increase in the size and

frequency of sudden shifts in the demand for the

country’s exports.

The Theory of


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The Theory of


Figure 20-7: An Increase in Output Market Variability

LL1

GG

LL2

2

2

Degree of economic integration

between the joining country and

the exchange rate area

Gains and losses

for the joining country

1

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What Is an Optimum Currency Area?

It is a region where it is best (optimal) to have a single

currency.

Optimality depends on degree of economic integration:

Trade in goods and services

Factor mobility

A fixed exchange rate area will best serve the

economic interests of each of its members if the degree

of output and factor trade among them is high.

The Theory of


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The Theory of


Figure 20-8: Intra-EU Trade as a Percent of EU GDP

The Theory of

Optimum Currency Areas Table 20-2: People Changing Region of Residence in 1986

(percent of total population)

Britain France Germany Italy Japan United States

1.1 1.3 1.1 0.6 2.6 3.0Source: Organization for Economic Cooperation and Development. OECD Employment Outlook . Paris: OECD,

July 1990, Table 3.3.

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Case Study: Is Europe an Optimum Currency

Area?

Europe is not an optimum currency area:

Most EU countries export form 10% to 20% of their output to

other EU countries.

EU-U.S. trade is only 2% of U.S. GNP.

Labor is much more mobile within the U.S. than within

Europe.

Federal transfers and changes in federal tax payments provide

a much bigger cushion for region-specific shocks in the U.S.

than do EU revenues and expenditures.

The Theory of


The Theory of


Figure 20-9: Divergent Inflation in the Euro Zone

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Table 20-1: A Brief Glossary of Euronyms

How the European

Single Currency Evolved

How the European


European Currency Reform Initiatives, 1969-1978

The Werner report (1969)

It set out a blueprint for the stage-by-stage realization of

Economic and Monetary Union by proposing a three-phase

program to:

Eliminate intra-European exchange rate movements

Centralize EU monetary policy decisions

Lower remaining trade barriers within Europe

Two major reasons for adopting the Euro:

To enhance Europe’s role in the world monetary system

To turn the European Union into a truly unified market

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The European Monetary System, 1979-1998

Germany, the Netherlands, Belgium, Luxemburg, France, Italy,

and Britain participated in an informal joint float against the

dollar known as the “snake.”

Most exchange rates could fluctuate up or down by as much as

2.25% relative to an assigned par value.

The snake served as a prologue to the more comprehensive

European Monetary System (EMS).

Eight original participants in the EMS’s exchange rate

mechanism began operating a formal network of mutually

pegged exchange rates in March 1979.

How the European


Capital controls and frequent realignments were essential ingredients in maintaining the system until the mid-1980s.

After the mid-1980s, these controls have been abolished as part of the EU’s wider “1992” program of market unification.

During the currency crisis that broke out in September 1992, Britain and Italy allowed their currencies to float.

In August 1993 most EMS currency bands were widened to ± 15% in the face of continuing speculative attacks.

How the European


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German Monetary Dominance and the Credibility Theory of the EMS

Germany has low inflation and an independent central bank.

It also has the reputation for tough anti-inflation policies.

Credibility theory of the EMS

By fixing their currencies to the DM, the other EMS countries in effect imported the German Bundesbank’s credibility as an inflation fighter.

Inflation rates in EMS countries tended to converge around Germany’s generally low inflation rate.

How the European


How the European


Figure 20-2: Inflation Convergence Within Six Original EMS Members,

1978-2000

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The EU “1992” Initiative

The EU countries have tried to achieve greater internal economic

unity by:

Fixing mutual exchange rates

Direct measures to encourage the free flow of goods, services, and

factors of production

The process of market unification began when the original EU

members formed their customs union in 1957.

The Single European Act of 1986 provided for a free movement of

people, goods, services, and capital and established many new

policies.

How the European


European Economic and Monetary Union

In 1989, the Delors report laid the foundations for

the single currency, the euro.

Economic and monetary union (EMU)

A European Union in which national currencies are

replaced by a single EU currency managed by a sole central

bank that operates on behalf of all EU members.

How the European


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Three stages of the Delors plan:

All EU members were to join the EMS exchange rate

mechanism (ERM)

Exchange rate margins were to be narrowed and certain

macroeconomic policy decisions placed under more

centralized EU control

Replacement of national currencies by a single European

currency and vesting all monetary policy decisions in a

ESCB

How the European


Three stages to Economic and

Monetary Union

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Maastricht Treaty (1991)

It set out a blueprint for the transition process from the

EMS fixed exchange rate system to EMU.

It specified a set of macroeconomic convergence criteria

that EU countries need to satisfy for admission to EMU.

It included steps toward harmonizing social policy within

the EU and toward centralizing foreign and defense policy

decision.

How the European


EU countries moved away from the EMS and toward

the single shared currency for four reasons:

Greater degree of European market integration

Same opportunity as Germany to participate in system-wide

monetary decisions

Complete freedom of capital movements

Political stability of Europe

How the European


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The Euro and Economic

Policy in the Euro Zone

The Maastricht Convergence Criteria and the Stability and Growth Pact

The Maastricht Treaty specifies that EU member countries must satisfy several convergence criteria:

Price stability

Maximum inflation rate 1.5% above the average of the three EU member states with lowest inflation

Exchange rate stability

Stable exchange rate within the ERM without devaluing on its own initiative

Budget discipline

Maximum public-sector deficit 3% of the country’s GDP

Maximum public debt 60% of the country’s GDP

Convergence criteria: more precisely

The inflation rate of a given Member State must not exceed by more than 1½ percentage points that of the three best-performing Member States in terms of price stability during the year preceding the examination of the situation in that Member State.

The annual government deficit: the ratio of the annual government deficit to gross domestic product (GDP) must not exceed 3% at the end of the preceding financial year. If this is not the case, the ratio must have declined substantially and continuously and reached a level close to 3%

The government debt: the ratio of gross government debt to GDP must not exceed 60% at the end of the preceding financial year.

The Member State must have participated in the exchange-rate mechanism of the European monetary system without any break during the two years preceding the examination of the situation and without severe tensions.

In practice, the nominal long-term interest rate must not exceed by more than 2 percentage points that of, at most, the three best-performing Member States in terms of price stability (that is to say, the same Member States as those in the case of the price stability criterion). The period taken into consideration is the year preceding the examination of the situation in the Member State concerned.

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Meeting convergence criteria:

Government budgetary position

As of March 1998, five Member States (Denmark, Ireland, Luxembourg, the Netherlands and Finland) are not the subject of a Council decision on the existence of an excessive deficit and so already fulfil this criterion. On the basis of the results for 1997, the Commission recommends that the Council abrogate the excessive deficit decisions for Belgium, Germany, Spain, France, Italy, Austria, Portugal, Sweden and the United Kingdom. In all, therefore, the deficits in fourteen Member States in 1997 were either below or equal to the 3% of gross domestic product (GDP) reference value.

While the government debt ratio was below the 60% of GDP reference value in 1997 in only four Member States (France, Luxembourg, Finland and the United Kingdom), almost all the other Member States have succeeded in reversing the earlier upward trend. Only in Germany, where the debt ratio is just above 60% of GDP

Greece has made substantial progress in recent years in reducing the imbalances in its public finances: it has reduced the government deficit from almost 14% of GDP in 1993 to 4.0% in 1997 and is expected to reach 2.2% in 1998;


Price stability

The reference value for price stability (calculated as the arithmetic average of the inflation rates in the three best performing Member States, namely France, Ireland and Austria, plus 1.5 percentage points) was 2.7%.

In January 1998 fourteen Member States (Belgium, Denmark, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal, Finland, Sweden and the United Kingdom) had average inflation rates below this reference value. In view of the institutional and behavioural changes brought about by the EMU process, there are strong reasons for believing that the current inflation performance of these fourteen Member States is sustainable.

Greece has achieved regular and significant progress in bringing the inflation rate down but, with an average inflation rate of 5.2% in January 1998, it still remains well above the reference value.

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Exchange rate stability

In practical terms, a country fulfils this criterion if its currency has participated in the exchange-rate mechanism (ERM) of the European Monetary System (EMS) for at least two years while remaining within the ±2.25% fluctuation margin around its central rate.

As of March 1998, ten currencies (the Belgian franc, the Danish krone, the German mark, the Spanish peseta, the French franc, the Irish pound, the Luxembourg franc, the Dutch guilder, the Austrian schilling and the Portuguese escudo) comply strictly with this criterion.

The vast majority of participating countries remained clustered close to their ERM central rates in the period under review (March 1996 to February 1998); only the Irish pound remained far above its central rate for an extended period of time. It was revalued by 3% against the other ERM currencies in March 1998.

The Finnish markka joined the ERM in October 1996 and the Italian lira re-entered the mechanism in November 1996, i.e. less than two years ago. However, they did not experience severe tensions in the two years under review.

The Greek drachma, the Swedish krona and the pound sterling did not participate in the ERM during the review period. However, the Greek drachma entered the ERM in March 1998.


Long term interest rate

Long-term interest rates can be seen as forward-looking indicators which reflect the financial markets' assessment of underlying economic conditions and cannot be directly influenced by national authorities. In January 1998 the reference value (calculated as the arithmetic average of the long-term interest rates of the three best performing Member States in terms of price stability plus two percentage points) worked out at 7.8%.

Fourteen Member States (Belgium, Denmark, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal, Finland, Sweden and the United Kingdom) had average long-term interest rates below the reference value.

Greece has also experienced declining interest rates over recent years, but at 9.8% the level of the long-term interest rate still remains well above the reference value.

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Which Member States fulfiled the convergence criteria in 1997

1997 Rate of inflation

Government budgetary position

Exchange rate Interest rates

Belgium Yes yes1 yes yes

Denmark Yes yes yes yes

Germany Yes yes1 yes yes

Greece No no no2 no

Spain Yes yes1 yes yes

France Yes yes1 yes yes

Ireland Yes yes yes yes

Italy Yes yes1 yes3 yes

Luxembourg Yes yes yes yes

Netherlands Yes yes yes yes

Austria Yes yes1 yes yes

Portugal Yes yes1 yes yes

Finland Yes yes yes4 yes

Sweden Yes yes1 no yes

United Kingdom Yes yes1 no yes

1 Abrogation of the Council Decision on the existence of an excessive deficit is recommended by

the Commission.



Figure 20-3: Behavior of the Euro’s Exchange Rates

Against Major Currencies

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A Stability and Growth Pact (SGP) in 1997 sets up:

The medium-term budgetary objective of positions close to

balance or in surplus

A timetable for the imposition of financial penalties on

counties that fail to correct situations of “excessive” deficits

and debt promptly enough



The European System of Central Banks

It consists of the European Central Bank in Frankfurt

plus 12 national central banks.

It conducts monetary policy for the euro zone.

It is dependent on politicians in two respects:

The ESCB’s members are political appointments.

The Maastricht Treaty leaves exchange rate policy for the

euro zone ultimately in the hands of the political authorities.



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The European Central Bank

(ECB)

The ECB consists of a Governing Council and an Executive Board.

The Governing Council comprises the governors of the national central banks and the members of the Executive Board of the ECB.

The Executive Board, which is made up of the President, the Vice-President and four other members, is effectively in charge of running the ECB.

Its President and members are appointed from among persons of recognised standing and experience in monetary or banking matters by common accord of the governments of the Member States, on a recommendation from the Council after it has consulted the European Parliament.

Their term of office is eight years which, in the interests of ensuring the independence of the Executive Board members, is not renewable (Article 112 EC).

The European System of Central Banks (ESCB) is composed of the ECB and of the central banks of the Member States (Article 107 EC).

It has the task of defining and implementing the monetary policy of the Community, and has the exclusive right to authorise the issue of banknotes and coins within the Community. It also holds and manages the official foreign reserves of the Member States and promotes the smooth operation of payments systems (Article 105(2) EC).

Summary Fixed exchange rates in Europe were a by-product

of the Bretton Woods system.

The EMS of fixed intra-EU exchange rates was

inaugurated in March 1979.

In practice all EMS currencies were pegged to the

DM.

On January 1, 1999, 11 EU countries initiated an

EMU by adopting a common currency, the euro.

Greece became the 12th member two years later.

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Summary

The Maastricht Treaty specified a set of

macroeconomic convergence criteria that EU

countries would need to satisfy to qualify for

admission to EMU.

The theory of optimum currency areas implies that

countries will wish to join fixed exchange rate areas

closely linked to their own economies through trade

and factor mobility.

The EU does not appear to satisfy all of the criteria

for an optimum currency area.

Nominal interest rates among

Eurozone countries

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Reference interest rates of

ECB and NBP

Perceived and real inflation rates

among Eurozone countries

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Budget deficit and level of debt in

relation to GDP in EU members (2008)

Meeting inflation criterion in

Poland

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Macroeconomic imbalances in

Greece

Greece: Twin deficts:

approaching the crisis

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Revealing the Greek crisis

To keep within the monetary union guidelines, the government of Greece had misreported the country's official economic statistics. Beginning of 2010, it was discovered that Greece had paid banks hundreds

of millions of dollars in fees since 2001 for arranging transactions that hid the actual level of borrowing.

Purpose of these deals made by several successive Greek governments was to enable them to continue spending while hiding the actual deficit from the EU.

Greek budget deficit In 2009, the government of George Papandreou revised its deficit from an estimated 6% (8% if a special tax for building irregularities were not to be applied) to 12.7%. In May 2010, the Greek government deficit was estimated to be 13.6% which is one of the highest in the world relative to GDP.

Greek government debt was estimated at €216 billion in January 2010. Accumulated government debt was forecast, according to some estimates, to hit 120% of GDP in 2010

The Greek government bond market relies on foreign investors, with some estimates suggesting that up to 70% of Greek government bonds are held externally.

Greek Bond spreads 1993-

2011

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Crisis in Greece

Austerity program in Greece

Public sector limit of €1,000 introduced to bi-annual bonus, abolished entirely for those earning over €3,000 a month.

An 8% cut on public sector allowances and a 3% pay cut for DEKO (public sector utilities) employees.

Limit of €800 per month to 13th and 14th month pension installments; abolished for pensioners receiving over €2,500 a month.

Return of a special tax on high pensions.

Changes were planned to the laws governing lay-offs and overtime pay.

Extraordinary taxes imposed on company profits.

Increases in VAT to 23%, 11% and 5.5%.

10% rise in luxury taxes and taxes on alcohol, cigarettes, and fuel.

Equalization of men's and women's pension age limits.

General pension age has not changed, but a mechanism has been introduced to scale them to life expectancy changes.

A financial stability fund has been created.

Average retirement age for public sector workers has increased from 61 to 65

Public-owned companies to be reduced from 6,000 to 2,000.

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Selected European and US Bank

Exposure to Greece (Dec. 2010)

Interest rate spreads over

German bonds

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Relative unit labor costs 2000-

2010

Fiscal and CA imbalances

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Public defict and debt in 2010

Imbalances in Portugal

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Imblances in Spain

Assistance for Greece, Ireland

and Portugal 2009-2011

Monetary union - wz.uw.edu.pl · Single Currency Evolved European Currency Reform Initiatives, 1969-1978 The Werner report (1969) It set out a blueprint for the stage-by-stage realization

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