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320.326: Monetary Economicsand the European Union

Lecture 9

Instructor: Prof Robert Hill

Monetary Union in the EU

De Grauwe – Chapters 7, 8, 9

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1. The Maastricht Treaty

The treaty signed in 1991 set the rules for monetary union 12 years later.

Entry into the monetary union was made conditional on satisfying convergence criteria.

A country would be eligible to join the union only if:(i) its inflation rate was not more than 1.5% higher than the average of the three lowest inflation EU countries.(ii) its long-term interest rate was not more than 2% higher than the average of the same three lowest inflation EU countries.(iii) it has joined the exchange rate mechanism (EMS) and has not experienced a devaluation during the two years prior to entry.

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(iv) the government budget deficit is not higher than 3% of GDP (or it must be declining steadily and come close to 3%, or it must be above 3% only because of some exceptional event).

(v) Government debt does not exceed 60 percent of GDP (if it does it should show a clear downward trend towards 60 percent).

In 1998 it was decided that 11 countries satisfied the conditions for membership (and also wanted to join). Greece soon after also satisfied the conditions.

Note: it has emerged since that the Greek statistics were “massaged” to meet the criteria.

The UK, Sweden and Denmark satisfied the conditions but chose not to join.

Slovenia joined the Eurozone in 2007, Cyprus and Malta in 2008, Slovakia in 2009, Estonia in 2011 and Latvia in 2014.

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Technically, monetary union started in 1999. At this point, the exchange rates of the member countries were fixed. The Euro (notes and coins) came into effect in 2002.

The national central banks of the member countries continue to exist. They maintain their decision making powers over banking supervision, and assist the ECB with the implementation of monetary policy.

2. Why Convergence Requirements?

(i) Inflation convergence to a low level

There was a desire (particularly in Germany) to ensure that the European Central Bank (ECB) would take a strong stance against inflation.

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The inflation convergence criterion was a way for the member countries to show their commitment to low inflation.

If all members of the Eurozone have similar inflation rates, this makes things easier for the ECB.

Unfortunately, some members countries had systematically higher inflation (which was not matched by faster growth in productivity) year after year, and hence became less competitive.

Becoming less competitive year after year while simultaneously running up a large government debt (e.g., in Greece and Italy) is a dangerous combination that may end in the government defaulting on its debt.

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(ii) Budget convergence and debt levels

Large budget deficits over time lead to large government debts. A government with a large debt has an incentive to inflate it away. The inflation fighting credibility of the monetary union will be greater if the government debts of the member countries are not too large.

Or a country with a large debt might default which could also undermine the credibility of the Euro zone. A default might then spread contagion since the holders of these bonds (often banks from other countries) may also get into difficulty.

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Why should the limit in the Maastricht treaty be a budget deficit of3% and government debt of 60% of GDP?

The upper debt limit is equal to the average debt to GDP ratio ofthe EU countries in 1992.

The government debt as a percentage of GDP (b) can be stabilized even while the government runs a deficit (d) if the growth rate of GDP (g) is high enough.

b will be stable if d=gb (see de Grauwe page 148 footnote 5 for a derivation of this result).

For example, suppose the government’s debt level is 60%, and GDP is growing by 5% per year. We obtain that d = 0.05 × 0.6 = 0.03. That is, the government can run a 3% deficit without increasing b, when b=0.6 and g=0.05. Is assuming g=0.05 realistic?

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The main concern with the deficit and debt criteria was that excessive deficits and debt might be inflationary.

There was not much if any discussion of how excessive debt could cause governments to default on their debt.

In retrospect, if all countries had stuck to the Maastricht criteria, then the Euro-zone crisis would not now be as severe as it is now. The Maastricht criteria however would not have prevented the crises in Ireland and Spain (see previous lecture).

Some prominent economists (e.g., Krugman and Buiter) were critical of the deficit and debt levels set by the Maastricht Treaty, saying they were arbitrary and did not allow countries to run big enough deficits during recessions.

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3. Expansion of the Euro-Zone

Slovenia joined the Euro-zone in 2007, Cyprus and Malta in 2008,Slovakia in 2009, Estonia in 2011 and Latvia in 2014. Lithuania was refused entry in 2007 since its inflation rate was 2.7%.

The average inflation rate of the three lowest inflation countries inthe EU (inflation was lowest in Sweden – a non-Eurozone country) was 1.1%. Lithuania failed to reach the inflation target by 0.1%.

Half the Euro-zone countries had inflation rates higher than2.7 percent – Spain (3.3%), Greece (3.4%), Ireland (3.7%), Luxembourg (3%), the Netherlands (2.7%), Portugal (3.1%).

2.7% is as close to the ECB’s “just under 2% target” as 1.1% is.

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Also, not all the original Euro-zone members satisfied all the criteria on entry – e.g., Belgium, Italy and Greece had debts levels that exceeded 100 percent of GDP (but were moving in the right direction). Also, Germany’s debt level exceeded 60% and was rising.

Hence Lithuania has been harshly treated. This may be becauseof a fear that further expansion of the Euro-zone could cause itto cease being an optimal currency area.

4. The Design of the ECB

The ECB has a mandate to maintain price stability and stabilize output and employment (provided the latter does not endanger the former).

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The ECB is less accountable than the Federal Reserve. The chairman of the Federal Reserve must testify before Congressperiodically. Congress has the power to change the statutes ofthe Federal Reserve with a simple majority vote.

The president of the ECB must testify before the EuropeanParliament (EP). The EP however does not have the power tochange the statutes of the ECB. These can be changed only through a change of treaty that requires a unanimous vote byall EU member states.

There is an absence of strong political institutions in Europe capable of exerting control over the ECB.

This and the vagueness of the Maastricht Treaty has allowed the ECB to redefine its objective as simply one of price stability.

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The ECB is hence the most independent central bank.

The ECB is also not very transparent. The minutes of the meetings of the Governing Council are not made public and it does not admit to having an explicit inflation target.

Mario Draghi, the current ECB president, has reoriented the ECB’s focus during the Eurozone crisis “to do what it takes to save the Euro”. This has entailed providing liquidity to banks even at the risk of creating inflation in the future.

5. The Problem of Large Budget Deficits and Debts

Greece’s budget deficit in 2011 was 9.5 percent of GDP and its debt was about 165 percent of GDP, well above the upper limits set by the Maastricht treaty.

Inflation in Eurozone

Source: ECB

Budget balance as a percentage of GDPEnd 2011 End 2012 End 2013

USA -8.7% -7.0% -4.1%China -1.8% -2.3% -2.0%Japan -8.3% -9.7% -8.2%UK -8.8% -7.9% -6.7%Norway +13.1% +13.4% +13.0%Saudi Arabia +14.3% +12.6% +6.0%===========================================Austria -3.6% -2.5% -2.9%France -5.8% -4.5% -4.1%Germany -1.0% -0.2% +0.1%Greece -9.5% -7.0% -2.2%Italy -4.0% -2.8% -3.2%Netherlands -4.2% -4.2% -3.5%Spain -6.5% -8.3% -7.1%(Source: The Economist)

Government debt in the Euro area and USA (% of GDP)

Source: European Commission, European Economy.

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Fourteen EU Member States had government debt ratios higher than 60% of GDP at the end of 2011:

Greece (165.3%), Italy (120.1%), Ireland (108.2%), Portugal (107.8%), Belgium (98.0%), France (85.8%), the United Kingdom (85.7%), Germany (81.2%), Hungary (80.6%), Austria (72.2%), Malta (72.0%), Cyprus (71.6%), Spain (68.5%) and the Netherlands (65.2%).(Source: Bloomberg Businessweek)

How did Greece accumulate such a large debt?

Banks and other market participants thought that Greek bonds were less risky once it joined the Euro. They thought there was no risk of depreciation and that no Eurozone country would default on its bonds.

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The Greek government was hence able to borrow much more that it otherwise could have and at much lower interest rates.

The Greek government put short term gain ahead of long term sustainability - (a good example of dynamic inconsistency) and borrowed too much.

The loss of competitiveness of the Greek economy after joiningthe Euro has now sent Greece into recession, thus furtherincreasing the debt-to-GDP ratio.

Attempts to reduce the government deficit are worsening the recession in Greece.

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Implications of default by Greek government

It depends on who holds Greek bonds? In October 2011, most were held by commercial banks, mutual and pension funds, sovereign wealth funds (SWFs) and central banks.

Commercial banks in Germany and France were particularly exposed.

Note: the EU/IMF portion of the pie chart (next slide) is in the form of direct loans rather than bonds. This is therefore unaffected by a bond default.

Private holders of Greek bonds have accepted a 50 percent haircut.

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October 2011

2020Source: Ben Chu, The Independent, 17 Oct 2011

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The 50 percent haircut has not helped Greece as much as one might think, since Greek banks and funds held a lot of the bonds. The Greek government may be forced to bail out these banks and funds hence adding again to its debt.

By the end of 2012, private sector holdings of Greek bonds had fallen quite a bit. Also, hedge funds had moved in to the market (buying bonds at steep discounts) in search of quick profits.

According to the New York Times (23 Dec 2012) some hedge funds earned 100 percent returns on Greek bonds in 2012. They bought at low prices and bet on EU intervention that caused a partial rebound of prices.

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6. The Organizational Structure of the ECB

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The Governing Council is the main decision making body of the ECB. It consists of the executive board of the ECB (president, vice-president, and four directors) and the governors of the 15 national central banks in the Euro-zone.

The Governing Council makes decisions on monetary policy, interest rates, reserve requirements, and the provision of liquidity.

It meets every two weeks in Frankfurt. Each member of the Council has one vote.

The Executive Board sets the agenda for meetings of the Council, and implements monetary policy decisions (including giving instructions to the national central banks).

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Under ECB rules, board members do not represent a particular country, nor are they responsible for keeping track of economic conditions in one country. All board members are jointly responsible for monetary policy for the entire Euro area.

The whole framework described in Figure 8.10 is called theEuro-system.

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This system may become more problematic with enlargement of the Euro-zone. The influence of the ECB executive board could be reduced too much, making it vulnerable to capture by regional blocks.

Also, smaller countries may exert too much weight (compared with their contribution to Euro-zone overall population).

In 2002, the Governing Council agreed that the number of governors with voting rights will be limited to 15, and that voting rights will rotate, with countries with larger populations voting more frequently now that membership exceeds 15.

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7. Monetary Policy in the Euro-zone

The desired interest rates according to the Taylor rule for each Euro-zone country in 2005 are shown in Figure 9.7. The corresponding inflation rates and output gaps are shown in Figures 9.5 and 9.6.

Note: a Taylor rule determines the target interest rate as a function of the inflation rate and output gap.

rt* = ρ + πt + a(πt – π*) + b xt where a,b>1

r* = target interest rate, π* = target inflation rate, π = actual inflation rate, x = output gap (i.e., y-yn), ρ = long term real interest rate.Here we set a=1.5, b=0.5, ρ = 2% and π* = 2%.

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The Taylor rule is particularly useful in situations where inflation is above its target level and the output gap is negative(i.e., stagflation).

The spread in desired interest rates (according to the TaylorRule) is quite large, ranging from just under 2% (the Netherlands) to 7% (Greece). With such a large spread, it is impossible for the ECB to find an interest rate that suits everyone.

Inflation is highest relative to its natural rate for the lower income members of the Eurozone.

This is consistent with the convergence of income levels in theEurozone. More rapidly rising wages in the lower income countries causes the price of nontradables to rise faster andhence inflation to be higher.

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But has productivity risen with wages in these countries?

The too low interest rates in some of the poorer EU countries may have helped trigger housing booms (Ireland and Spain are prominent examples) and/or inflation and hence a loss of competitiveness (Greece and Italy).

See Figure B17.2.

A cross-section regression of real interest rates against house price changes further supports this hypothesis.

See Figure B17.3.

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