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?
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
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.
The Theory of
Optimum Currency Areas
The Theory of
Optimum Currency Areas
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
The Theory of
Optimum Currency Areas
The Theory of
Optimum Currency Areas
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
PEMU
PH0 PP0
PH
PP
W/H
W/P WP
UP UH
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
Optimum Currency Areas
The Theory of
Optimum Currency Areas
Figure 20-6: Deciding When to Peg the Exchange Rate
Gains and losses for the joining country
LL GG
Gains exceed losses Losses exceed
gains
1
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
Optimum Currency Areas
The Theory of
Optimum Currency Areas
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 1
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
Optimum Currency Areas
The Theory of
Optimum Currency Areas
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 3.0
Source: Organization for Economic Cooperation and Development. OECD Employment Outlook . Paris: OECD, July 1990, Table 3.3.
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
Optimum Currency Areas
The Theory of
Optimum Currency Areas
Figure 20-9: Divergent Inflation in the Euro Zone
Table 20-1: A Brief Glossary of Euronyms
How the European Single Currency Evolved
How the European
Single Currency Evolved
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
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 Single Currency Evolved
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
Single Currency Evolved
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 Single Currency Evolved
How the European Single Currency Evolved
Figure 20-2: Inflation Convergence Within Six Original EMS Members,
1978-2000
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 Single Currency Evolved
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
Single Currency Evolved
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 Single Currency Evolved
Three stages to Economic and
Monetary Union
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 Single Currency Evolved
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
Single Currency Evolved
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.
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;
Meeting convergence criteria:
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.
Meeting convergence criteria:
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.
Meeting convergence criteria:
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.
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.
The Euro and Economic Policy in the Euro Zone
Figure 20-3: Behavior of the Euro’s Exchange Rates
Against Major Currencies
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 Euro and Economic Policy in the Euro Zone
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.
The Euro and Economic
Policy in the Euro Zone
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 12
thmember two years later.
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
Reference interest rates of ECB and NBP
Perceived and real inflation rates
among Eurozone countries
Budget deficit and level of debt in relation to GDP in EU members (2008)
Meeting inflation criterion in
Poland
Macroeconomic imbalances in Greece
Greece: Twin deficts:
approaching the crisis
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
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.
