Title: Macroeconomic Policies in the EU Course given by Kiril Strahilov, PhD at MGIMO, Russia 7-10 October 2006
1Macroeconomic Policiesin the EUCourse given by
Kiril Strahilov, PhD at MGIMO, Russia7-10
October 2006
2Course Outline
1. European Macroeconomic Policies 1.1. Brief
Revision of European Monetary Integration 1.2.
Recent Macroeconomic Developments in the Euro
Area 1.3. Macroeconomic Policy Settings 1.4. The
External Dimension. 2. The Euro Area as an
Optimum Currency Area (OCA) 2.1. Benefits of
OCAs 2.2. Costs of OCAs 2.3. Costs and Benefits
compared 3. Monetary and Fiscal Policies in the
Euro Area. 9) 3.1. Institutional Aspects of the
ECB Credibility, Accountability and
Independence. 3.2. The Transmission Mechanism of
Monetary Policy 3.3.The Reform of the Stability
and Growth Pact 4. The Euro Area Enlargement
The Road of the Ten new EU Members towards
EMU 5. European Unemployment Basic Facts 5.1.
The Initial Rise of Unemployment the Role of
Shocks 5.2. Continuing Unemployment Sources of
Persistence 5.3. High Unemployment the Role of
Institutions
3Bibliography
- Blanchard, O. (2006). European Unemployment.
Economic Policy Journal, pp. 7-59. - De Grauwe, Paul (2006). Economics of Monetary
Union. 6th edition. Oxford University Press,
Oxford - European Central Bank (2004). The Monetary Poly
of the ECB. ECB, Frankfurt. - European Commission (2006). Annual Report on the
Euro Area 2006. Directorate General for
Economic and Financial Affairs. - Schadler, S. et al (2005). Adopting the Euro in
Central and Eastern Europe. Challenges of the
Next Step in European Integration. IMF Occasional
Paper 234. - Zestos, George K. (2006). European Monetary
Integration. The Euro. Thomson south-Western,
London
41. European Macroeconomic Policies
- 1.1. Brief Revision of European Monetary
Integration
5Bretton Woods Regime(fixed exchange rates)
- Stable exchange rates, but adjustable
- US dollar fixed in terms of gold (35 an ounce)
- fixed parity for other currencies in terms of
dollar - band around dollar parity plus or minus 1.0
- adjustment of parities after consultation with
the IMF - adjustments discouraged, allowed in case of
serious balance of payments disequilibria,
postponed by IMF loans - Central Banks of member countries hold reserves
in gold or dollars - and have right to sell dollars for gold to
Federal Reserve
6Bretton Woods Regime(fixed exchange rates)
- Consequences
- dollar becomes the international currency
(international dollar standard or gold exchange
standard) - dollar takes on role of reserve currency
(interest bearing) - Central Banks must intervene in foreign exchange
markets to stabilise the exchange rate of their
currencies by buying and selling dollars
7Problems of B-W regime
- Problem 1 Nth Currency Problem
- two currencies means one exchange rate
- (N currencies mean N-1 independent exchange
rates) - both countries cannot independently fix the
exchange rate. - EITHER both co-operate (symmetric solution)
- OR one follows a policy of benign neglect
(asymmetric solution). Role played by the USA - Problem 2 Realignments
- definition changing the exchange value of a
currency. - rendered difficult by the rules of the regime
- postponed as much as possible.
- Result
8Problems of B-W regime
- Problem 3 Speculative attacks
- Exchange rate value loses credible
- Massive sales (normally) or purchases of the
currency. - Breakdown of Bretton-Woods regime
- Inflation rises in the United States of America
- accelerates because of expansionary fiscal and
monetary policies (Vietnam war) - Two effects
- Purchasing power value of US falls
- Other countries import American inflation. (see
further) - Markets start selling dollars in large quantities
- Movement started by request of the Banque de
France (de Gaulle) to USA to convert its dollar
holdings into gold (exorbitant privilege).
9Problems of B-W regime
- Breakdown of Bretton-Woods regime (contd)
- August 15th 1971. Nixon closes gold window
- December 1971. Smithsonian Agreement general
realignment and increase of band to plus or minus
2.25 - March 1973 free floating
- Strong fluctuations of European currencies
against the dollar and, therefore, even
stronger fluctuations between the European
currencies - 1976 Jamaica Agreements (official end to
Bretton-Woods period) - In this context, the European Monetary System
(EMS) is born.
10First Steps Towards European Monetary Integration
- Establishment of the European Payments Union
(EPU) with effect from July 1950. - Principal purpose of EPU facilitate payments for
trade in goods between the OEEC member countries
in a world where currency convertibility was
still an issue. - The EPU was a clearing union that replaced the
existing agreements by a multilateral settlement
and credit mechanism - bilateral claims and liabilities for each country
were consolidated on a monthly basis in a single
net position which defined the balance of
payments situation of the country vis-à-vis the
rest of the EPU countries.
11First Steps Towards European Monetary Integration
- Settlements could occur by payment in gold or
dollars, or by automatic credit limited by
quotas. - EPU set up to allow OEEC countries to liberalise
trade in goods during the transition to currency
convertibility. - Eichengreen (1993) immediate introduction of
currency convertibility would have required large
devaluations in addition to the currency
realignments of 1949 and a consequent immediate
loss in real income. Introduction of EPU avoided
this, and gave member countries the time to
redeploy their economies before rendering their
currencies fully convertible. Without the EPU,
multilateral trade in goods would have been
endangered.
12First Steps Towards European Monetary Integration
- The Shuman Declaration of May, 9th 1950
- The Treaty of Paris signed in April 1951
established the European Coal and Steel Community
(ECSC) - Common market for the two commodities,
eliminating tariffs and quotas between the six
member states
13First Steps Towards European Monetary Integration
- Messina Conference (Sicily) in June 1955
possibility of establishing a Customs Union was
studied - On March 25th 1957 two more treaties were signed
European Economic Community (EEC) and the
European Atomic Energy Community (EURATOM)
14First Steps Towards European Monetary Integration
- On 1 January 1958, the Treaty creating the
European Economic Community (EEC) took effect. - Monetary matters were one of the least concerns
in the Treaty. Exchange rate policies came under
the jurisdiction of the International Monetary
Fund (IMF). - The Treaty did require that the Member States of
the newly formed EEC follow economic policies
which were compatible with the Brettton-Woods
commitments - currency convertibility, -
stable nominal exchange rates, and -
liberalisation of capital markets to the
extent necessary to ensure the proper
functioning of the common market (Article
67, EEC)
15First Steps Towards European Monetary Integration
- and with fundamental economic policy objectives
(balance of payments equilibrium, high level of
employment and a stable level of prices). - The Treaty also required of the Council of
Ministers of the Member States that they ensure
the coordination of the general economic policies
of the Member States (Article 145). - The general rules regarding economic and monetary
policies were laid down in Articles 104 to 109
and for the liberalisation of capital movements
in Articles 67-73. - A Monetary Committee was created with a purely
advisory role.
16First Steps Towards European Monetary Integration
- One event in this period is telling the German
revaluation of 1961, but its lessons were not
learnt when the Maastricht revision of the Treaty
was undertaken. - Germany was subject to inflationary pressures
both on account of a high level of domestic
demand and large surpluses in the balance of
payments current account. - A restrictive monetary policy on its own would
have led, and did lead, to an increase in capital
inflows and in inflationary pressures. - It also resulted in an excessive squeeze on
domestic demand. - A revaluation of the currency was not encouraged
by the IMF nor by certain domestic authorities. - The German central bank, the Bundesbank, did not
have the authority to revalue the currency which
was a competence of the Federal Government.
17First Steps Towards European Monetary Integration
- In the end, the Bundesbank was obliged to stop
its restrictive monetary policies, - and a revaluation of the Deutsche Mark occurred.
- The conflict between internal and external
balance could have been avoided to a large extent
- if both monetary and exchange rate policies had
been under the same authority. - But is this politically feasible?.
18First Steps Towards European Monetary Integration
- Meeting of Heads of State or Government of the
EEC at the Hague in December 1969 - Requests Council of Ministers to draw up a plan
by stages for creation of an economic and
monetary union. - task proves difficult because of opposing
economist and monetarist views. - economists first a high degree of convergence
in economic fundamentals and policies - monetarists rapid introduction of a monetary
union followed by economic convergence
19First Steps Towards European Monetary Integration
- Creation of Werner Commission in March 1970 to
address the issue. - Werner Report (October 1970)
- complete liberalisation of capital flows
- monetary union irrevocable fixing of exchange
rates - community system of national central banks
- centralised economic policy
- to be achieved in 3 stages completed by 1980
- compromise between economist view and
monetarist view
20First Steps Towards European Monetary Integration
- Werner project endorsed by European Council in
1971 but... was overtaken by events - The Marjolin Committee declared the project dead
in 1975 - The Snake (in the Tunnel)
- block floating between March 1973 and Dec. 1978
- tunnel between April 1972 and March 1973
- members change frequently and realign frequently
- snake lasts till 13 March 1979
21Creation of the European Monetary System (EMS)
- 13 March 1979 EMS comes into existence
- Result of initiative taken by Roy Jenkins in Oct.
1997 and followed up by Helmut Schmidt (German
Chancellor) and Valéry Giscard dEstaing (French
President) - Based on a European Council Resolution dated5
December 1978 - Main characteristics and operating procedures
contained in an Agreement Between all the
Central Banks of the Member States of the EEC. - Defined a system of fixed but adjustable exchange
rates between participating countries.
22How EMS addressed Bretton-Woods Regime Problems
- Asymmetry
- introduction of ECU
- a basket of currencies of all Member States
- each currency in the basket assigned a weight
- the weight could change over time
- replaced European Unit of Account
23The ECUA basket of all EC currencies
Belgian franc Belgian (3.301) and Luxembourg
(0.13) franc
24How EMS addressed Bretton-Woods Regime Problems
- Asymmetry (contd)
- introduction of an Exchange Rate Mechanism
- participation in ERM not obligatory
- each participating currency assigned a
(bilateral) central parity with respect to each
of the other participating currencies (defines a
parity grid ) - maximum variation of 2.25 on either side of
central parity allowed - Italy granted exception of 6 on either side.
25How EMS addressed Bretton-Woods Regime Problems
- Asymmetry (contd)
- obligatory and unlimited intervention at the
margin - suppose 1 DEM equalled 20 BEF (central parity)
- market exchange rate could vary between 19.55
and 20.45 BEF - if market rate reached either bound, both the
Belgian National Bank and the German Bundesbank
had to intervene in the market
26How EMS addressed Bretton-Woods Regime Problems
- Asymmetry (contd)
- obligatory and unlimited intervention at the
margin (contd) - if the exchange rate rose to 20.45 (appreciation
of mark and depreciation of franc) - the Bundesbank and the Belgian National Bank
would have to sell marks and buy francs - German Bundesbank at an advantage because it
could print as many marks as it needed - Belgian National Bank at a disadvantage because
it had a limited stock of marks to sell. - Why oblige both to intervene?
27How EMS addressed Bretton-Woods Regime Problems
- Asymmetry (contd)
- obligatory and unlimited intervention at the
margin (contd) - because as a result of the intervention, the
German money supply increased and the Belgian
money supply decreased - German interest rates fell and Belgian interest
rates rose, stabilising the exchange rate
28How ERM addressed Bretton-Woods Regime Problems
- Realignment
- At the request of one or several countries
participating in the ERM, a consultation occurred
involving the Ministers of Finance and the
Governors of the Central Banks of all the
participating countries. - These decided whether and to what extent a
realignment should take place. - Consequently, realignments were carried out
rapidly and with the agreement of the
participating countries. - The consultation often limited the extent of the
realignment out of fear of loss in
competitiveness.
29How ERM addressed Bretton-Woods Regime Problems
- Speculative Attacks
- obligatory and unlimited interventions by the two
Central Banks whose currencies were involved - markets would then know that between them the
Central Banks would not run out a currency - this would reduce the probability of a
speculative attack
30Functioning of ERM of EMS
- Four phases in the functioning of the ERM
- March 1979 to March 1983
- Participating countries going there own way
policy-wise. 7 realignments. - April 1983 to January 1987
- Participating countries beginning to recognise
the constraints on policy imposed by the ERM. 4
realignments. - February 1987 to September 1992
- The hard EMS. 1 technical realignment
(Italy). - October 1992 to end 1998
- the period following the breakdown of the EMS
and preceding monetary union
31Functioning of ERM of EMS
- Four phases in the functioning of the ERM
32Functioning of ERM of EMS
33Functioning of ERM of EMS
- Why did the ERM break down in Sep. 1992?
- Remote causes
- the system had become too rigid
- markets convinced no more realignments before
monetary union (Delors effect) - loss of competitiveness of certain countries
- large capital flows into high interest rate
countries (Italy, Spain and Portugal) - is this compatible with interest rate parity?
- risk premium.
34Functioning of ERM of EMS
- Why did the ERM break down in Sep. 1992?
- Remote causes (contd)
- the system had become asymmetric and dependent on
Germany - the Bundesbank set the interest rate for Germany
- the other ERM countries tied their currencies to
the German mark - the other ERM countries adapted their interest
rate to Germanys - In the ERM, Germany played the role that the USA
played under Bretton-Woods
35Functioning of ERM of EMS
- Why did the ERM break down in Sep. 1992?
- Proximate causes
- capital flows (liberalisation of capital flows in
1990) - the Bundesbank hikes up its interest rate after
re-unification - Maastricht Treaty vote in Denmark and in France
- Solution either floating exchange rates or move
to monetary union - Britain chose floating
- as did Italy and Spain temporarily
- fluctuation margins increased to 15 on both
sides of central parity
36Functioning of ERM of EMS
- Impossible or Incompatible Trinity
- independent monetary policy
- that is, achieve an internal target
- fixed exchange rates
- that is, achieve an external target
- free movement of capital
- One of these three goals must be given up.
37Transition to a Monetary Union
- The Delors Report
- The Maastricht Treaty
- The 3 stages
- Stage Two preparing for monetary union
- establishment of the European Monetary Institute
- countries shall endeavour to avoid excessive
fiscal deficits - the criteria for membership
- Stage Three monetary union
38- Criteria for membership
- The government deficit may not exceed 3 of Gross
Domestic Product at market prices. - If it does, the Commission must take into
account - whether it has declined substantially
- and continuously or
- the excess is temporary in nature. Furthermore,
it must examine whether the deficit exceeds
expenditure on investments as well as certain
other elements
39- Criteria for membership (contd)
- Government debt may not exceed 60 of Gross
Domestic Product. - If it does, the Commission should take into
account - - whether the ratio is diminishing
- sufficiently and
- - approaching the reference value at a
- satisfactory speed.
40- Criteria for membership (contd)
- The inflation rate is sustainable
- and, over the year preceding examination,
- does not exceed by more than 1.5
- that of, at most, the 3 best performing
- Member States.
- The consumer price index shall be used
41- Criteria for membership (contd)
- Long term interest rates (on long-term government
bonds or comparable assets) shall not exceed, - over the year preceding examination,
-
- by more than 2
- that of, at most, the 3 best performing Member
States in terms of inflation rates.
42Criteria for membership (contd) 5. The Member
State - shall have participated in the ERM
of the EMS and - respected the normal
fluctuation margins without severe tensions
for at least two years before the
examination. It shall not have devalued its
currency against any other Member State's
currency on its own initiative for the same
period.
43Criteria for membership (contd) Some authors
also add a legal convergence criterion, i.e., the
countries legislation should conform to the
Treaty in matters such as central bank
independence and the ESCB Statute.
44Transition to Membership
- Public finances consolidation
- EMU as deflationary? or stock adjustment?
- Exchange rate mechanism
- Real convergence
- not included in Maastricht Treaty criteria
- was not a problem for old Member States
- but may be one for new Member States
45The Path of the Euro
461.2. Recent Macroeconomic Developments in the
Euro Area
471.2. Recent Macroeconomic Developments in the
Euro Area
- Following Relative mild downturn in 2001-2003,
the euro-area economy experienced a comparatively
slow recovery - In 2006 economic growth is expected to accelerate
(EC Commission forecast 2.6 increase in GDP
for 2006) with countries like Finland, Greece,
Spain, Ireland and Luxembourg growing more than 3
.
481.2. Recent Macroeconomic Developments in the
Euro Area
- The euro-areas economic recovery is underpinned
by a strengthening of domestic demand,
particularly investment - Total Investment is expected to grow by 4.2
- This is due mainly to historically low interest
rates, improved corporate balance sheets - The Outlook for consumption in the Euro Ares in
2006 is for a modest upturn 1.7 increase
491.2. Recent Macroeconomic Developments in the
Euro Area
501.2. Recent Macroeconomic Developments in the
Euro Area
- The euro-areas economic recovery is also being
helped by the continued strong expansion of world
output and trade - World GDP at 4.6 (strong overall performance in
China, India, Japan and USA) - World trade growth in 2006 is expected to be
around 8 - with EU exportsto the rest of the
world growing by 5.5
511.2. Recent Macroeconomic Developments in the
Euro Area
521.2. Recent Macroeconomic Developments in the
Euro Area
- The European Commission expects consumer price
inflation to remain at 2.1 in the euro area in
2006 - Core inflation (CPI excluding energy and
unprocessed food) continued to decline and stood
at 1.5 in May 2006 - Oil prices have recently reached record high
levels of 70 USD per barrel of Brent crude oil. - According to Commission estimates price per
barell in 2006 will average 68.9 USD (27.4
increase compared to 2005). Effect on Euro area
CPI should be moderate (see box 1.1)
531.2. Recent Macroeconomic Developments in the
Euro Area
541.2. Recent Macroeconomic Developments in the
Euro Area
551.2. Recent Macroeconomic Developments in the
Euro Area
- Potential risks to continued investment growth in
the EU - Further increasing oil prices
- The impact of the budgetary consolidation in
Germany (increase of VAT from 16 to 19)
German households may bring forward some
purchases of durable consumer goods. Hence
German GDP is expected to fall slightly in 2007
561.3. Macroeconomic Policy Settings
571.3. Macroeconomic Policy Settings
- The overall aim of macroeconomic policy in the
euro area is to keep output close to potential,
whilst preserving price stability. - In the medium term minimization of uncertainty
of households and businesses about future
macroeconomic policies stimulating consumption
and investment decisions - The short term responsiveness of policies is
essential as economic circumstances change
continuously.
581.3. Macroeconomic Policy Settings
- Monetary conditions Monetary policy has helped
to spur economic activity and promote confidence
through historically low nominal and real
interest rates. - Recent increases should help to anchor medium- to
long-term inflation expectations (see graph 2.2) - Interest rates are very low from historical
perspective the lowest interest rate ever
attained by the German Bundesbank (BuBa) was 2.5
591.3. Macroeconomic Policy Settings
601.3. Macroeconomic Policy Settings
- Inflation rates have stayed close but above the
ceiling of 2 per cent. - Long-term inflationary expectations are below 2
(see graph 2.4). - The euro-areas economic recovery has coincided
with a remarkable degree of wage moderation (due
to the behavior of social partners) Low wage
growth can help to reduce inflationary
expectations. - On the contrary high inflationary expectations
lead to high inflation and may jeopardize the
economic recovery.
611.3. Macroeconomic Policy Settings
621.3. Macroeconomic Policy Settings
- Fiscal Policy Fiscal policies remain the
responsibility of individual member states, but
there are some general requirements set in the EC
Treaty and in the SGP. - Member states can make e positive contribution to
economic growth by improving the quality if their
public finance. - The euro area is already burdened with too high
level of debt (see graph 2.8)
631.3. Macroeconomic Policy Settings
641.3. Macroeconomic Policy Settings
- Another reason to improve the sustainability of
public finances is the additional budgetary
pressure that will stem from the ageing of the
euro-areas population (see graph 2.9). - Change of the old-age dependency ratio
- Pressure on public finances
- Conclusions EMUs policy framework has
contributed to a very favourable macroeconomic
policy mix.
651.3. Macroeconomic Policy Settings
661.4. The External Dimensions
671.4. The External Dimensions
- Since its launch in 1999, the euro has become the
second most important international currency,
behind the US Dollar. - In the first half of 2006, the euro appreciated
against the US dollar and the Japanese Jen,
having depreciated in both cases in 2005 (see
graph 4.1) - Interest rate differentials (see graph 4.3) and
global imbalances (see graph 4.4) will play a
role in determining whether there will be
continued appreciation of the euro or a further
dollar strength.
681.4. The External Dimensions
691.4. The External Dimensions
701.4. The External Dimensions
- In 2005 US posted the largest current account
deficit of its history - 6.4 of its GDP - Due to persistent differences in saving and
investment behavior in US. - Although the euro area has a roughly balanced
current account, it would not be immune to
effects of a disorderly correction in global
imbalances.
711.4. The External Dimensions