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Title: Joining a Monetary Union: Europes Great Monetary Experiment


1
Joining a Monetary Union Europes Great
Monetary Experiment
  • Eduard Hochreiter
  • Joint Vienna Institute
  • Wilfrid Laurier University
  • Thursday, September 27, 2007
  • 3.00 p.m.

2
Overview
  • Introduction
  • A Look at History
  • The Architecture of Maastricht incl Coordination
    of Macro Policies
  • Benefits and Costs of Joining a MU
  • Institutional Requirements for Joining EMU
  • Economic Issues Regarding The Adoption of the
    Euro
  • The Adoption of the Euro The Case of Greece
  • Experiences with EMU
  • Some general conclusions

3
Introduction
  • Exciting experiment
  • born out of will to prevent wars
  • nourished by market integration
  • entering adulthood with the introduction of the
    euro
  • complex political institutional economic
    interaction European integration perspective ?
    difference to other regions
  • lecture pinpoints important institutional
    economic issues

4
2. European Integration Europes Great
Monetary Experiment A Brief Look At History - 1
  • 1950 European Payments Union (EPU)
  • 1952 European Coal and Steel Community (ECSC)
  • 1957 Treaty of Rome
  • 1958 European Economic Community (EEC)
    EURATOM
  • 1960 European Free Trade Association (EFTA)
  • 1970 Werner Report Create EMU within a Decade
  • 1972 European Currency Snake
  • 1979 European Monetary System (EMS)
  • 1986 Single European Act
  • 1990 Stage 1 of EMU
  • 1992 Maastricht Treaty
  • 1993 Single Market for Four freedoms a reality

5
2. European Integration Europes Great
Monetary Experiment A Brief Look At History - 2
  • 1994 Stage Two of EMU EMI (European Monetary
    Institute)
  • 1995 Fixing of starting date of Stage Three of
    EMU Euro
  • 1997 Amsterdam Treaty - SGP
  • 1998 ECB decision on 11 initial EMU members
  • 1999 Stage Three of EMU
  • 2001 Greece 12th Euro Area-member
  • 2002 Issuance of euro coins and banknotes
  • 2004 Ten new EU-MS, mainly from CEE
  • 2007 BG ROM join EU Slovenia 13th Euro
    Area-member
  • 2008 Cyprus and Malta14th and 15th Euro
    Area-member
  • 2009 Slovakia becomes the 16th Euro Area-member?

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6
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7
3. The Architecture of the Maastricht Model - 1
  • Historical uniqueness of EMU
  • National states formally give up sovereign
    monetary policy in peacetime and transfer it to a
    supranational, independent institution the ESCB.
  • Maastricht Treaty (MT) Price stability as basic
    common public good of the EU. The MT enshrines
    the European stability culture.

8
3. The Architecture of the Maastricht Model - 2
  • Amsterdam Treaty SGP
  • SGP clarifies and modifies EDP
  • establishes an early warning system by setting
    up yearly stability programs to be submitted by
    MS
  • defines medium term budgetary objective of
    positions close to balance or in surplus
  • sets strict deadlines for the application of
    the EDP
  • invites the imposition of sanctions
  • Reform of the SGP 2005

9
Reform of the SGP 2005-1-
  • 3 (for budget deficit) and 60 (for public debt)
    reference values remain unchanged.
  • Preventive arm changes
  • Medium term objective close to balance or in
    surplus (CTBOIS) zero to surplus ? broadened to
    1 (high growth low debt countries) to zero to
    surplus (low growth high debt)
  • and CTBOIS now country-specific
  • Implies European Commission now more room for
    discretion and interpretation
  • More symmetric ? consolidation in good times
  • No EDP when G-deficit gt 3, if overshooting
    due to temporary factors and remaining close to
    the reference value
  • ? Long list of temporary deviations from MT
    objective (e.g. structural reforms)

10
Reform of the SGP 2005-2-
  • Corrective arm changes
  • No triggering of EDP, if economic growth
    contracts by more than 2.
  • ? Broadened to" negative growth or a period of
    low growth
  • Long list of exceptional circumstances, e.g.
    cyclical position, RD, financial contributions
    to foster international solidarity, the
    unification of Europe, etc.
  • Minimum fiscal adjustment 0.5 p.a., if not
    CTOBOIS
  • Extension of deadlines of EDP
  • Repeating of procedural steps possible
  • Extension of correction period ? 2 years
    (Portugal 3 years already!!)

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11
3. The Architecture of the Maastricht Model - 3
  • Monetary Policy centralized at euro area level
    and oriented towards an area-wide objective the
    maintenance of price stability (defined by the
    System itself).
  • Fiscal Policy predominately remains in the
    national domain, subject to the Treaty constraint
    that national economic developments must not
    influence monetary conditions in the euro area in
    a negative way.
  • GUIDING PRINCIPLES
  • sound public finances Art 4(3) economic
    policies a matter of common concern (Art. 99)
  • No bailout clause (Art. 103)
  • EDP (Art. 104) --- Maastricht Treaty
  • SGP (Council Regulations 1466/97, 1467/97 and
    Council Resolution 97/C236/01-02) --- Amsterdam
    Treaty

12
3. The Architecture of the Maastricht Model - 4
  • 2 major issues
  • Question Are there sufficient incentives for
    sound fiscal policies in EMU AFTER the adoption
    of the euro?
  • What are sound, i.e. sustainable fiscal
    policies?
  • Fiscal rules and coordination among fiscal
    policies
  • Question How to secure the consistency of (only
    loosely coordinated) national fiscal policies
    with the area-wide stability-oriented monetary
    policy.
  • Is there a case for ex ante coordination between
    fiscal and monetary policies?

13
3. The Architecture of the Maastricht Model
What are sound, i.e. sustainable fiscal policies?
  • change in government debt at time t
  • g government expenditure exclusive of interest
    payments
  • t government revenue except seigniorage
  • net interest payments, i.e. difference
    between the nominal interest rate and nominal
    GDP growth
  • change in monetary base seigniorage

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14
3. The Architecture of the Maastricht Model - 5
  • (ad 1) Potential conflicts among national fiscal
    policies. How to discipline fiscal policy? Do we
    need fiscal rules in EMU?
  • Problem 1 excessive deficits in one region
    spread over the union incentive for governments
    to overspend (in SR) ? externalization of fiscal
    excesses smaller rise in interest rate FREE
    RIDING PROBLEM
  • Problem 2 if so, bailout? (in LR) to avoid
    bankruptcy ? potential cost of bailout spread
    over the union smaller rise in inflation MORAL
    HAZARD PROBLEM
  • HENCE ? (binding) fiscal rules (of some kind,
    e.g. SGP) recommended on economic grounds to
    avoid lax fiscal policies.

15
3. The Architecture of the Maastricht Model - 6
  • Coordination of fiscal and monetary policies
  • The economics debate How are fiscal and monetary
    policies related?
  • Monetary and fiscal policy are linked through
    the intertemporal budget constraint (expected
    sum of expenditure exp. sum of revenues) in
    EMU seigniorage is exogenous for govt. hence
    budget constraint must be met in LR to avoid
    bankruptcy.

16
3. The Architecture of the Maastricht Model - 7
  • What does theory tell us regarding the
    benefit/need to ex ante coordinate fiscal and
    monetary policy?
  • In simple two-player game theoretic models it can
    be shown that policy coordination improves the
    policy outcome (move from non-cooperative to
    bargaining equilibrium raises welfare reduction
    of spillover effects)
  • BUT Who takes the lead in fiscal policy in EMU?
    Will all the other (fiscal) players fall in line?
    Are all players symmetrically informed? Is the
    economic model agreed? How sizeable are the
    welfare gains?
  • ? Many uncertainties!

17
3. The Architecture of the Maastricht Model - 8
  • Is there a need for fiscal rules?
  • Static macro model IS-LM are independent ?
    NO
  • Neoclassical perspective if Riccardian equiv.
    holds or, if not, financial markets are efficient
    (sovereign credit risk is reflected in risk
    premia) ? NO
  • Dynamic macro model Maastricht Model UMA
    (Sargent-Wallace) turns into UFA
    (Winckler-Hochreiter-Brandner) ? YES
  • Fiscal theory of the price level in the case
    of a fiscal shock monetary policy, ultimately,
    must produce enough (inflation tax) revenue for
    the state to remain solvent (see formula above)
    fiscal dominance ? NO
  • ALTERNATIVELY reduce G or raise T to secure the
    LR solvency of the state (see formula above)
    monetary dominance

18
3. The Architecture of the Maastricht Model - 9
  • Fiscal policy surveillance and coordination
  • Multilateral surveillance of fiscal policies
    European Commission
  • Coordination through ECOFIN institutional flaw
    as ECOFIN decides on existence of ED, the
    measures to be taken and the sanctions levied!
  • Central instrument of policy coordination BEPGs
    under the Mutual Surveillance Procedure (Art. 99)
  • ? comprises the guiding principles of economic
    policy making in a medium term perspective of 3
    years for the EU, euro area and each MS.

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19
4. Benefits and Costs of Joining a MU - 1 -
  • Benefits
  • Lower transaction costs (OCA) ? trade effects
    (beyond that of fixed exchange rates) Rose
    2000, Glick Rose 2001, Frankel Rose 2002.
  • Other micro efficiency gains (no exchange rate
    risk lower interest rate differential deeper
    financial integration seigniorage gain through
    international use of currency ().
  • Higher business cycle sycronicity ? endogeneity
    of OCA
  • More real growth and reduced output and inflation
    variability

20
4. Benefits and Costs of Joining a MU - 2 -
  • Costs
  • Loss of monetary policy instrument
  • Loss of seigniorage
  • Higher real exchange rate persistence
  • Cost of asymmetric shocks

21
4. Benefits and Costs of Joining a MU - 3 -
  • Assessment for Europe (Hochreiter et. al, 2002,
    Table 2).
  • BENEFITS
  • savings on transaction costs (EC 1990 forex
    interbank transactions 0.5 p.a. R.
    Mendizábal 2006 0.69 p.a. max.)
  • other micro gains all positive impact on growth
    most financial deepening ? substantial growth
    effects gt 0.5 p.a.
  • higher BC synchronization (Böwer and Guillemineau
    2006 and lower volatility (EC 2007).
  • growth benefits beyond that of fixed exchange
    rates through single currency ? Rose Effect,
    i.e. tripling of trade (Rose 2000), 30 to 90
    trade growth for Euro Area (Rose and Stanley
    2005).
  • additional seigniorage through international use
    of currency ? small

22
4. Benefits and Costs of Joining a MU - 4 -
  • COSTS
  • loss of autonomy for monetary policy can also be
    a blessing (e.g., Greece Hochreiter Tavlas
    2005)
  • asymmetric shocks negligible for most EU
    members but, possibly size-related (sticky
    domestic adjustment mechanisms).
  • (Net) Loss of seigniorage negligible, if at all.

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23
5. Institutional Requirements of The Adoption of
the EuroThe Maastricht Convergence Criteria - 1
  • EMU membership is part of the legal EU Treaty
    framework, the "Acquis communitaire".
  • Hence, with EU entry also EMU and ESCB
    membership, but with a derogation
  • Euro adoption a right AND a Treaty obligation (no
    opt-out clause)
  • precondition for euro adoption fulfillment of
    Maastricht convergence criteria

24
5. Institutional Requirements of The Adoption of
the EuroThe Maastricht Convergence Criteria - 2
  • Inflation criterion an (sustainable) inflation
    rate not more than 1 1/2 higher than those of
    the three best performing EU countries (EU 27!!)
    over the latest 12 months.
  • ? Does this make sense in EMU?
  • Fiscal convergence criteria
  • (a) a general government budget deficit of not
    more than 3 of GDP, unless either the reference
    value was exceeded only temporarily or
    exceptionally and remains close to the reference
    value, or the ratio has declined substantially
    and continuously and reached a level close to the
    reference value.
  • ? Too restrictive? not enough room for
    manoeuvre? Procyclical?

25
Derivation of 3 deficit reference value
where d level of debt bp primary balance b
overall balance i nominal interest
rate r real interest rate rate of
inflation ge government expenditure g real
growth rate t taxes
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26
5. Institutional Requirements of The Adoption of
the Euro The Maastricht Convergence Criteria - 3
  • (b) a government debt ratio of not more than 60
    of GDP unless the ratio is approaching that
    level at a satisfactory pace.
  • ? not enough emphasis on level of debt?
  • 3. Interest rate criterion an average nominal
    long term interest rate that does not exceed by
    more than two percentage points that of the three
    best performing member states in terms of price
    stability.
  • ? not really controversial
  • 4. Exchange rate criterion participation in the
    Exchange Rate Mechanism (ERM II) of the European
    Monetary System (EMS) within the normal
    fluctuation margin without severe tensions for at
    least two years and without having requested a
    devaluation.
  • ? useless or even counterproductive?

27
Accession Criteria - 1
Source European Commission
28
Accession Criteria - 2
Source European Commission
29
Accession Criteria - 3
Source European Commission
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30
6. Economic Issues Regarding The Adoption of
the Euro -1
  • Fast or slow?
  • If net gains large and costs falling over time
    ? quick adoption
  • If benefits and costs balanced and benefits
    rise over time ? take your time
  • All subject to fulfillment of Maastricht
    criteria!

31
6. Economic Issues Regarding The Adoption of
the Euro - 2
  • Some major issues
  • (Prudent) Fiscal positions (e.g. Hungary)
  • Inflation (-differentials) ?
    Balassa- Samuelson effects (e.g. Estonia,
    Lithuania)
  • Capital flows (Sudden stops and reversals)
  • Financial sector development

32
6. Economic Issues Regarding The Adoption of
the Euro - 3
  • Vulnerabilities
  • Capital account volatility (policy
    inconsistency, asymmetric shocks, exit date
    risks)
  • Credit booms
  • Economic booms
  • Possible strategies to minimize risks up to the
  • reduce fiscal deficits, contain inflationary
    pressures and maintain growth (structural
    adjustment)

33
6. Economic Issues Regarding The Adoption of
the Euro - 4
  • Entry into Time spent in ERM II
  • New EMS can join ERM II any time after EU
    accession.
  • training room - or waiting room approaches
  • Strategies
  • Adopt Euro as soon as possible and in ERM II
    as late as necessary (i.e. gt 2 years before
  • Participate in ERM II as soon as possble and
    then take time to prepare for Euro adoption
  • Wait and See approach
  • Risks of (untimely) ERM II entry
  • Risk for too tight a corset
  • Risk for too loose a corset
  • Risk of speculative attacks

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34
7. The Adoption of the Euro The Case of Greece
- 1
  • Greece EU 1981, at the time an EME at best (low
    income, high volatility, underdeveloped financial
    markets, etc.), highly regulated, capital
    controls, quite closed economy, political
    business cycles, structural rigidities.
  • Until mid-1990s inconsistent policies, fiscal
    dominance, futile search for nominal anchors
    (independent monetary policy an asset?),
    speculative attacks, currency crises, current
    account driven balance of payments crises wage
    excesses, huge, persistent disequilibria, key
    economic indicators 1981 1995
  • average inflation rate 20 p.a.,
  • average budget deficit 10 p.a.,
  • public debt from lt20 to 120 of GDP
  • average real growth 1 p.a.

35
7. The Adoption of the Euro The Case of Greece
- 2
  • 1995 Fundamental political decision to pursue
    policies that will allow Greece to introduce the
    euro in 2001 ? fundamental, sustained policy
    shift, anchored at Maastricht
  • stability-oriented monetary policy
    (pre-announced) hard currency peg),
  • fiscal consolidation,
  • tight prudential regulation and supervision of
    banks,
  • structural adjustment (privatization, wage
    bargaining processes, deregulation, financial
    market liberalization).
  • 1998 ERM entry AFTER policies set and intended
    euro adoption date (2001) credible!
  • Strong political will, broad political support,
    and adequate economic policies DECISIVE

36
7. The Adoption of the Euro The Case of Greece
- 3
  • ERM entry (March 1998) with a devaluation
  • Thereafter significant Drachma appreciation with
    some volatility but very smooth exchange rate
    development as of spring 1999!
  • Credibility of maintaining adequate policies
  • Credibility of endpoint/exit! ( conversion rate)

37
7. The Adoption of the Euro The Case of Greece
- 4
  • Svensson test for Greece

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38
7. The Adoption of the Euro The Case of Greece
- 5
  • March 16, 1998 Central rate ECU/EUR 1 GRD
    353.109
  • January 17, 2000 New CR GRD 340. 75
    Conversion rate

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39
7. The Adoption of the Euro The Case of Greece
- 6
  • What about (independent) use of monetary policy
    in the run-up to the euro?
  • Recall Impossible Trinity fixed exchange
    rates and open capital account ? no monetary
    independence!
  • But, Greece
  • Use of tight monetary policy to reach inflation
    criterion until late 2000.
  • High real interest rates did cause significant
    capital inflows sterilizing interventions bought
    time at the cost of come 0.5 of GDP.

40
The Impossible Trinity
Free Capital Movements
Let exchange rate float to maintain monetary
independence
Use monetary policy to maintain exchange rate peg
Independent Monetary Policy
Pegged Exchange Rate
Capital controls
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41
7. The Adoption of the Euro The Case of Greece
- 7
Back
42
7. The Adoption of the Euro The Case of Greece
- 8
  • Conclusions on Greek experiences
  • EMU provides the special circumstances to make
    the middle to be stable.
  • Only enter ERM II once convergence policies are
    CREDIBLY enacted and on track.
  • Importance of credible exit date and common view
    on conversion rate

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43
8. Experiences with EMU- 1 -
  • Positive results
  • How to deal with heterogeneity in EMU?
  • Growth divergence
  • ? working of adjustment mechanisms
  • Inflation divergence
  • ? matter for concern or a normal phenomenon?
  • ? endogeneity of OCA criteria (labor mobility,
    fiscal transfers)

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44
8. Experiences with EMU Growth convergence - 2 -
Back
45
8. Experiences with EMU- 3 -
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46
9. Some General Conclusions - 1
  • EMU is a unique experiment combining a
    supranational monetary policy with still
    national, albeit loosely coordinated, fiscal
    policies.
  • EMU has a very important political dimension. ?
    Sets it aside from other regions thinking about a
    MU.
  • Policy coordination in EMU and EU mostly is about
    coordination among fiscal policies and between
    fiscal and other economic policies and NOT
    between fiscal and monetary policies.

47
9. Some General Conclusions - 2
  • The Maastricht Treaty stipulates that in case of
    inconsistencies between fiscal and monetary
    policy the former has to yield to the latter the
    Maastricht framework is one of monetary dominance
    as opposed to fiscal dominance.
  • The Treaty does not foresee ex ante co-ordination
    between fiscal and monetary policies.
  • Greece offers some useful insights for EU
    countries that as yet have not adopted the Euro.

48
THE END
  • THANK YOU
  • FOR YOUR ATTENTION!
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