The Challenge of Enlargement of Euroland

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The Challenge of Enlargementof Euroland

• Paul De Grauwe
• University of Leuven

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• The launch of the euro has been an
  extraordinarily successful operation
• Yet there are challenges ahead
• The main challenge comes from the enlargement

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• Several issues
• Is a Eurozone of 25 countries an OCA?
• How will enlargement affect costs and benefits of
  EMU for the present members?
• Can an enlarged Eurozone continue to function as
  it does today?

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1.Is a Eurozone of 25 countries an OCA?
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The traditional theory

• Definition of OCA
• According to traditional theory of OCAs, the
  optimality of currency areas depends on three
  variables
• Openness (integration)
• Asymmetry of shocks
• Flexibility

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Costs and benefits monetary unionasymmetry and
flexibility

• In OCA-zone
• benefits of EMU exceed costs
• Asymmetry of shocks is compensated by flexibility
• Outside OCA-zone
• Reverse holds

asymmetry
OCAI
OCA-zone
flexibility
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• Nature of OCA-zone
• benefits of EMU exceed costs
• countries find the cost of not being able to use
  their national monetary policies to deal with
  asymmetric shocks small compared to the benefits
  of the union.
• Union central bank is not perceived to neglect
  national monetary conditions when setting unique
  interest rate.
• Monetary policy that fits one size is not
  perceived to be costly.

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Costs and benefits monetary unionasymmetry and
openness

• In OCA-zone
• benefits of EMU exceed costs
• Asymmetry of shocks is compensated by opennes
  (integration)
• Outside OCA-zone
• Reverse holds

asymmetry
OCAII
OCA-zone
Openness (integration)
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Evidence Openness
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Evidence Asymmetry of shocks
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• Central European countries are relatively open to
  rest of EU
• More so than the UK
• Central European countries subject to more
  asymmetric shocks
• This is also the case for UK
• Missing links
• Flexibility we know very little about this

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Is EU-25 an OCA?asymmetry and openness

• EU-25 is likely to be outside OCA-zone
• There is a large component of uncertainty
• Endogenous nature of dynamics towards OCA
  OCA-criteria could be selffulfilling

asymmetry
OCAII
EU-25
OCA-zone
opennes
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• Complicating factor
• Many countries see monetary union as instrument
  to import monetary stability
• Cfr. Southern European countries prior to EMU
• Central European countries today
• As a result traditional OCA-analysis plays little
  role in decision to join
• Once monetary stability is achieved traditional
  OCA-analysis will reappear with a vengeance

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2. Implications of enlargement for present
eurozone
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Implications of enlargement for present eurozone

• EU-25 less integrated and more subject to
  asymmetric shocks than EU-12
• original members of Euroland (who are also part
  of EU-25) have to wait longer to reach OCA-zone
• Some original members will perceive policies of
  the ECB to be less receptive to shocks than
  before the enlargement

divergence
OCA
EU-25
EU-12
openness (integration)
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• perceived costs of the union will increase
  relative to the perceived benefits of the single
  currency.
• tensions inside the Eurosystem increase
  when some countries feel that their economic
  interests are not served well by the ECB.

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• ECB can do very little about this
• Nevertheless it is likely to get part of the
  blame
• Greater acceptance that the ECB cannot deal with
  national problems

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IntermezzoShould UK join EMU?

• Openness UK relatively little openness
• Asymmetric shocks are relatively large
• Flexibility

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• UK is relatively closed towards EU
• UK experiences relatively large asymmetric shocks
• BUT, UK has more labour market flexibility
  allowing it to better adjust to these shocks
• Benefits may be higher than costs
• Cost-benefit calculus for member countries may
  deteriorate

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What is the right euro/pound rate at entry?
Pound seems to be overvalued, although this is
still uncertain If overvalued, there will be a
problem that will have to be solved collectively
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3. Enlargement and institutional reform
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• present system equal representation of each
  member country in the Governing Council
• such a system works satisfactorily today.
• will it work well when Eurozone has 25 countries?

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Present situation a lot of asymmetric shocks
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• Asymmetric developments of inflation and output
  growth create different desires about the
  interest rate that should apply for Eurozone
• We can measure these desires by the Taylor rule

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• Taylor rule
• rt a b?t cxt
• rt nominal interest rate
• ?t inflation
• xt output gap

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Present situation asymmetric distibution of
desired interest rates using Taylor Rule (2002)
Assumptions Governors are nationalistic ECB-board
cares about Euro-wide interests Conclusion ECB-Bo
ard has strategic position despite asymmetries in
shocks
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Conclusion of previous analysis

• Today the ECB-Board has strategic position within
  Governing Council. (Its interest rate proposal is
  close to median)
• This is maintained even when distribution of
  desired interest rates is very different among
  large and small countries.
• This decision making process ensures that the
  interest rate that is decided is the optimal one
  from the point of view of the Eurozone as a
  whole.

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• This is so even if national governors are guided
  by economic conditions prevailing in their own
  countries.
• This decision making model also ensures that
  large countries (France, Germany, Italy)
  interests are relatively well served, despite the
  overrepresentation of the small countries in the
  Governing Council.
• Consensus is easy to reach and formal voting
  usually unnecessary

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After enlargement asymmetric distibution of
desired interest rates
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• In enlarged Eurozone the ECB-Board will loose its
  strategic position.
• Its interest rate proposals will occasionally be
  overruled by coalitions of small countries who
  experience different economic conditions than the
  average (which is dominated by the large
  countries).
• Interest rate decisions will be made on the basis
  of economic conditions that prevail in a
  relatively small part of Euroland.

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• This will lead to grave conflicts within the
  Eurosystem.
• Consensus model is likely to break down.
• The essence of the problem small countries are
  over-represented in the Governing Council
• in enlarged Eurosystem this will have fatal
  effect that interest rate decisions may not
  always be made on the basis of the average
  economic conditions that prevail in the union.

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How to solve this problem?

• The importance of small countries in the
  Governing Council must be reduced
• so that the strategic position of the Board can
  be maintained.
• Several possible formulas

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• Possible formulas
• US Fed formula all governors participate in
  deliberations of Governing Council but voting
  rights are restricted to a limited number of
  governors (e.g. ten) on a rotating basis.
• The IMF formula small countries group together
  in constituencies and are represented by one
  governor.
• The centralisation formula the decision making
  is centralised in the Executive Board of the ECB.
  In this formula there is scope for expanding the
  size of the Board.
• ECB-proposal is mix of formula 1 and 2

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Conclusion

• It is unlikely that a Eurozone of 25 members is
  an OCA today
• It may become one in the future
• Many countries want to join so as to achieve
  monetary stability. This may not be a good
  motivation.
• Enlargement is likely to make the Eurozone less
  attractive for present members
• Enlargement will require important institutional
  changes within the Eurozone.