Lecture 21 Oca Emu

Optimal Currency Areas and the EMU
J. Prestmo
International Macroeconomics
29th of October 2015
J. Prestmo EMU Lecture 29.10.2015 1 / 38

Ouline
Outline
1 Introduction and Background
2 The European Monetary System: Before the Euro
3 The European Monetary Union
4 The Economics of EMU

Cost of a Common Currency
Solutions?
The theory of Optimal Currency Areas
5 The Successes and Failures of the EMU
6 The Euro Crisis and the Future of EMU

Introduction and Background
EU and Euro Zone

How the Euro Zone Evolved
Why did European countries decided to form a currency area after the
collapse of Bretton Woods?
Build a single unified market of comparable size to US
Exploit gains from internal trade under exchange rate stability
avoiding speculative attacks / currency crises
A new macroeconomic power backed by a single currency which
possibly competes with dollar as an international unit of account
Key Issues
Gradual ceding of national economic policy powers: loss of
sovereignty
Setting up supranational institutions
Establish rules for national fiscal policies

Initiatives for Market Integration
Critical requirement to form currency area: removing national

barriers to trade and fostering market integration
1957: Treaty of Rome: European Economic Community
Belgium, France, Germany, Italy, Luxembourg and the Netherlands
form a common market
First enlargements: Denmark, Ireland, UK join in 1973, Greece in
1981
Incomplete customs union in some strategic industries:
government-imposed standards, national licensing / government
purchases distorted competition favoring domestic firms
1986: Single European Act
Crucial step in removing trade barriers, harmonization of national
laws concerning trade and product standards

The European Monetary System: Before the Euro
European Monetary System
1979-1998 European Monetary System / Exchange Rate Mechanism

1979-1993: Mutually Pegged Exchange Rates within narrow
bands
1979: Fixed rates between France, Germany, Italy, Belgium,
Denmark, Ireland, Luxembourg, Netherlands
Enlargements: Spain (1989), Britain (1990), Portugal (1992)
Official ERM mechanism: peg to ECU
Central parities established with respect to ECU (European
Currency Unit), a weighted bundle of currencies
Fluctuation margins: 2.5%, realignments possible
Exchange rates interventions were coordinated between
appreciating-currency countries and depreciating-currency
countries
Some countries kept financial controls to avoid speculative attacks

Actual mechanism: peg to Deutsche Mark

ECU was not in circulation banks use DM as foreign reserves (and,
in case, use it to intervene on FOREX to defend parity with DM)
The officially symmetric ECU-based system turns out to be an
asymmetric reserve currency system based on DM
Why did countries accept it?
The credibility theory of EMS
Late 1970s: wide inflation gaps (second oil shock)
Bundesbanks established reputation as a inflation-fighter
Monetary authorities of inflation-prone countries gain credibility by
tying their own hands (expectations / penalty of speculative attacks)
Did it work?


It did work until 1992...

Inflation was tamed during the 1980s
The possibility of realignments was often exploited during
1979-1987
Role of financial controls
Realignments typically induce some loss of reputation
FOREX agents tend to punish less credible countries with
speculative attacks
Financial controls allowed countries to minimize this cost:
realignments inducing a reputation loss could not erupt into big
speculative attacks
1987: Tightening of EMS
Financial controls are removed
Central banks lose most of residual independency

1992-1993 Crisis of the ERM

1989-1991: Reunification of Germany
Excess Aggregate Demand in Germany: need to build
infrastructures for half of the new country
Upward pressure on German price level, Bundesbank will not let
inflation go
The N-th Currency Problem strikes back
Bundesbank enacts restrictive monetary policies to stabilize prices
All countries must follow, including UK (deep recession), France
(stagnation), Italy (under severe fiscal restrictions)
Collapse of fixed parities
Strong speculative attacks on Italian Lira, British Pound, French
Franc
Some countries leave, others negotiate 15% fluctuation margins

The European Monetary Union
Despite the 1993 crisis, the EU managed to adopt a single

currency
Fixed but adjustable exchange rates bear the risk of speculative
attacks forcing devaluations/revaluations: A single currency is more
credible (no-turning-back point)
ECB is not the Deutsche Bundesbank: guarantees more
symmetry than a reserve currency system
Question at that time: what criteria should countries satisfy to
join?
Inflation criteria to avoid the need of centralized monetary
restrictions hurting low-inflation countries
Fiscal discipline criteria to avoid insolvent behavior of one country
in spite of rigorous members

The Maastricht Treaty
December 1991: Maastricht Treaty. Before joining Euro Area...

1 The countrys inflation rate must be no more than 1.5% above the
average rate of the three EU member states with the lowest
inflation
2 The country must have maintained a stable exchange rate without
devaluing
3 The country must have a public sector deficit no higher than 3% of
its GDP
4 The country must have a public sector debt below 60% of its GDP
or approaching this reference level at satisfactory speed
Ongoing monitoring of (3) and (4) even after the adoption of Euro

The Maastricht Treaty
Logic behind fiscal criteria:

A liquidity crisis in one country (i.e., no demand for public bonds
no funds to finance public expenditures) would put pressure on
ECB to purchase unsold bonds inflationary monetary
interventions going to the detriment of virtuous countries
Drawback:
After giving up monetary policy, national governments are also
limited in fiscal policies
1997 Stability and Growth Pact (SGP)
Further tightening: medium-term budgetary objective of positions
close to balance or in surplus
Procedure of excessive deficits establishing penalties for
countries not satisfying criterion (3)
...the SGP has subsequently been watered down...

The Economics of EMU
Economics of EMU
From now on: Suggested Readings

1 Selected Excerpts from De Grauwe, P., Economics of Monetary
Union (6th edition)
The Costs of a Common Currency
The Theory of Optimum Currency Areas: A Critique
2 De Grauwe, P., European Monetary Union, The New Palgrave
Dictionary of Economics (on-line, 2011)
Successes of EMU
Failures of EMU
Future Prospects

The Economics of EMU
Theory of Optimum Currency Areas

Mundell (1961), McKinnon (1963), Kenen (1969)
Concentrates on the costs of giving up national currency
Focuses on the pre-conditions countries should satisfy to enter a
monetary union and gain from it
Emphasis
Asymmetric Shocks
Income Transfers
National Fiscal Policies

The Economics of EMU Cost of a Common Currency
Shifts in demand (Mundell)

Consider the standard Aggregate Demand / Aggregate Supply
model of macroeconomics
Aggregate Demand is a negative relationship between real output Y
and domestic price level P reflecting substitution effects / monetary
effects
Aggregate Supply is a positive relationship between real output Y
and domestic price level P reflecting profit opportunities / marginal
production costs
Crucial parameters
Preferences aggregate demand
Wages aggregate supply


Two-Country setting: France vs Germany
Asymmetric Shock
Consumers shift their preferences away from French-made to
German-made products
France
Aggregate Demand shifts down
Lower price level PF , lower real output YF
Excess labor supply / unemployment
Germany
Aggregate Demand shifts up
Higher price level PG , higher real output YG
Excess labor demand / overemployment


Asymmetric shock in favor of german products

Shifts in demand (Mundell): Possible adjustment mechanisms?

1 Labor market: wage flexibility
2 Labor market: labor mobility
3 Unemployment in France, Inflation in Germany
4 Devaluation in France / Revaluation in Germany


Mechanism (1): wage flexibility
Wages decline in France, increase in Germany
AS expands in France, AS shrinks in Germany


Mechanism (2): labor mobility
French workers migrate to Germany
Unemployment disappears in France
Overemployment disappears in Germany
Mechanism (3): unemployment in France, inflation in Germany
No wage flexibility / no labor mobility?
France remains in the same situation
Germany: shock induces overemployment. In the long run, either
higher wages or insufficient labor AS shrinks in Germany, output
declines, prices increase


Mechanism (4): devaluation in France / revaluation in Germany
This mechanism pushes towards the initial (pre-shock) situation by
operating on the demand side of both countries

The Economics of EMU Solutions?

A monetary union implies no possibility for revaluation / devaluation
Economies may respond to asymmetric shocks via flexible wages /
labor mobility
If there is no wage flexibility / labor mobility, asymmetric shocks
induce unemployment in France, inflation in Germany
These considerations led Mundell to establish the classic
proposition of the theory of Optimum Currency Areas:
An optimal currency area requires that the countries exhibit high
degrees of wage flexibility and/or of labor mobility

Monetary Union without Fiscal Union

Monetary authorities become supranational while governments
conduct their own fiscal policies
Should national budgets be unified as well?
Concerning asymmetric shocks... Some say yes because EMU
could then have automatic stabilizers
against asymmetric shocks
Some say no because automatic stabilizers are not politically
acceptable if transfers become permanent and one-way: national
fiscal authorities can deal with asymmetric shocks by public debt
policy (trading intertemporally)

Monetary Union without Fiscal Union

Concerning solvency...
Some say yes: budget centralization could allow direct control over
as well as reputation gains for debt-prone countries
Some say no: fiscal policy is the last bit of economic-policy
sovereignty remaining to governments. Let fiscal policies be
national but subject to explicit constraints (logic of the Maastricht
Treaty). The market will punish insolvent behavior through higher
interest rates on debt-prone countries.

The Economics of EMU The theory of Optimal Currency Areas
The Theory of OCAs
The classic arguments of OCA theories emphasize asymmetric

shocks: are these events a crucial problem in Europe?
Critique of OCA theories
Pre-conditions argument: countries are not so different, shocks are
symmetric
Endogeneity argument: after joining EMU, countries become (even)
less prone to asymmetric shocks
Plain considerations
The pre-conditions argument is an empirical issue
The endogeneity argument deserves attention: does the creation of
EMU itself tend to make EMU an optimal currency area?

Economic Integration and Vulnerability to Shocks
European Commission View vs Krugman View

Arguments for ...
European Commission View

In Europe, trade is mainly intra-industry trade...
Countries sell to each other the same categories of products
Product differentiation imperfect competition
Pre-conditions argument
Producing similar goods sectoral shocks hit all countries similarly
Asymmetric shocks are not a crucial problem
Endogeneity argument
Joining the EMU removal of trade barriers
Further intra-industry trade asymmetric shocks become even
less likely

Arguments against...
Krugman View
Endogeneity argument
Joining the EMU removal of trade barriers
Increased trade leads to regional concentration of sectors /
industries because of the exploitation of economies of scale
Increased regional concentration makes the supply-side structures
of economies more diversified asymmetric shocks become more
likely

Economic Integration and Vulnerability to Shocks
Empirical Evidence?
Rose (2000; 2002), Rose-Van Wincoop (2001): Monetary Unions
and Trade Flows
Creation of a Currency Area doubles trade flows among members
Subsequent research suggests more modest, but still big impacts
on trade flows
Artis and Zhang (1995), Frankel-Rose (1998): Monetary Unions
and Asymmetric Shocks
Increased integration led to more correlated business cycles / less
asymmetric shocks
So far, European Commission seems right...

The Successes and Failures of the EMU
(Second suggested reading: De Grauwe, P., European Monetary

Union, The New Palgrave Dictionary of Economics, 2011)
Successes of EMU
Unification via a peaceful process
Elimination of transaction costs in international trade
Elimination of exchange-rate risk in financial transactions
Inflation in line with the target: average rate of 2.2% over the first
ten years ECB quickly gained credibility
Euro increasingly used as a reserve currency

Failures of EMU
Unit labor costs and GDP growth rates are sensibly different...

Failures of EMU
Ongoing Weaknesses of EMU

1 Independent national fiscal policies are themselves sources of
asymmetric shocks
2 Lack of fiscal discipline entails costs for other countries
3 During solvency/liquidity crises, supranational currency
supranational Central Bank leave the single country without a
lender of last resort
Note (2)-(3) as ingredients of the sovereign debt crisis 2009-2012
Lack of fiscal discipline...
Greece public deficit (5%) contained tricks: actual deficit was 13%
Market fled Greek Bonds, huge spreads with German bonds
Contagion effects: Ireland, Portugal, Spain, Italy

The Euro Crisis and the Future of EMU
Government Bond and the Eurozone Debt Crisis

EMU and the Debt Crisis
Note differences...
Fears if default applied to different countries for different reasons
Ireland, Spain: banks & housing bubbles
Portugal: international borrowing
Belgium, Italy: high public debt
Still, risk premia reflected the size of public deficits...

Increasing debt

No lender of last resort...

The single countries could not ask their own central banks to buy
public bonds and print new money
No dedicated agency like IMF existed at the EU level
Temporary Solution?
European Financial Stability Facility (EFSF), European Financial
Stabilisation Mechanism (EFSM)
EFSF backed by countries shares in ECB and by IMF; EFSM backed
by the EU Commission budget
Idea: Issue bonds to raise funds used to provide loans to eurozone
countries in trouble
ECB made sterilized open market operations
May 2010: ECB purchased bonds of countries in trouble, sold US
assets to keep money supply unchanged
Other country-specific bailout packages

Future Prospects: New Governance?

New Governance?
Huge debate about the role of ECB in purchasing public debt bonds
Avoid liquidity crises induced by speculative attacks or supranational
lender of last resort for insolvent States?
Creation of European Stability Mechanism (ESM) replacing the
temporary EFSF/EFSM
Conditions for accessing loans subject to debate
More general issue, beyond solvency crises
How to re-gain ability to make counter-cyclical budgetary policies
when EMU fiscal constraints bind?
Debate about centralized budget, direct control over fiscal issues,
political problems...

Lecture 21 Oca Emu

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Lecture 21 Oca Emu

Uploaded by

Copyright:

Available Formats

Optimal Currency Areas and the EMU

J. Prestmo EMU Lecture 29.10.2015 1 / 38

1 Introduction and Background

2 The European Monetary System: Before the Euro

3 The European Monetary Union

4 The Economics of EMU

5 The Successes and Failures of the EMU

6 The Euro Crisis and the Future of EMU

J. Prestmo EMU Lecture 29.10.2015 2 / 38

EU and Euro Zone

J. Prestmo EMU Lecture 29.10.2015 3 / 38

How the Euro Zone Evolved

J. Prestmo EMU Lecture 29.10.2015 4 / 38

Initiatives for Market Integration

Critical requirement to form currency area: removing national

J. Prestmo EMU Lecture 29.10.2015 5 / 38

European Monetary System

1979-1998 European Monetary System / Exchange Rate Mechanism

J. Prestmo EMU Lecture 29.10.2015 6 / 38

European Monetary System

Actual mechanism: peg to Deutsche Mark

J. Prestmo EMU Lecture 29.10.2015 7 / 38

European Monetary System

J. Prestmo EMU Lecture 29.10.2015 8 / 38

European Monetary System

It did work until 1992...

J. Prestmo EMU Lecture 29.10.2015 9 / 38

European Monetary System

1992-1993 Crisis of the ERM

J. Prestmo EMU Lecture 29.10.2015 10 / 38

The European Monetary Union

Despite the 1993 crisis, the EU managed to adopt a single

J. Prestmo EMU Lecture 29.10.2015 11 / 38

The Maastricht Treaty

December 1991: Maastricht Treaty. Before joining Euro Area...

J. Prestmo EMU Lecture 29.10.2015 12 / 38

The Maastricht Treaty

Logic behind fiscal criteria:

J. Prestmo EMU Lecture 29.10.2015 13 / 38

From now on: Suggested Readings

J. Prestmo EMU Lecture 29.10.2015 14 / 38

Cost of a Common Currency

Theory of Optimum Currency Areas

J. Prestmo EMU Lecture 29.10.2015 15 / 38

Cost of a Common Currency

Shifts in demand (Mundell)

J. Prestmo EMU Lecture 29.10.2015 16 / 38

Cost of a Common Currency

Shifts in demand (Mundell)

J. Prestmo EMU Lecture 29.10.2015 17 / 38

Cost of a Common Currency

J. Prestmo EMU Lecture 29.10.2015 18 / 38

Shifts in demand (Mundell): Possible adjustment mechanisms?

J. Prestmo EMU Lecture 29.10.2015 19 / 38

Shifts in demand (Mundell)

J. Prestmo EMU Lecture 29.10.2015 20 / 38

Shifts in demand (Mundell)

J. Prestmo EMU Lecture 29.10.2015 21 / 38

Shifts in demand (Mundell)

J. Prestmo EMU Lecture 29.10.2015 22 / 38

Shifts in demand (Mundell)

J. Prestmo EMU Lecture 29.10.2015 23 / 38

Monetary Union without Fiscal Union

J. Prestmo EMU Lecture 29.10.2015 24 / 38