economic and monetary union in europe ram mudambi, ph.d. fox school of business & management,...
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Economic and Monetary Union in Europe
Ram Mudambi, Ph.D.Fox School of Business & Management,
Temple University, USAEMBA BA 804
Ram Mudambi / Temple U and U of Reading 3
The EU - A relative view, 1998
1998 GDP (US$bn) % of World GDP % of World Trade
EU 15 8369 29.4 20*The US 8424 29.5 18Japan 3801 13.3 10.3ROW 7924 27.8 51.7
SOURCES: OECD national statistics, Jan.2000, UNCTAD, World Bank, WTO* Excludes intra-EU trade
Ram Mudambi / Temple U and U of Reading 4
The EU - A relative view, 2003
*Merchandise trade only. + Excludes intra-EU trade..
Share of WorldShare of World
Exports* Imports*GDPGDP
(World Share)
The US
The EU
Japan
10,933.5(31.2%)
10,500.2(30.0%)
4,300.9(12.3%)
12.7%
19.3%+
8.3%
21.9%
18.7%+
6.4%
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HISTORY• In 1945, in the immediate aftermath of
World War II, Winston Churchill proposed a ‘United States of Europe.
• EMU is rooted in the notion of European integration and the desire of European nations sought to prevent a re-occurrence of war on the continent.
• The guiding principles of the EMU have always been political rather than economic.
Those who forget history are doomed to repeat it
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Origins of EMU
• The basic idea is that European integration will create strong institutions with vested interests in preserving peace.
• EMU is composed of two parts:– Economic union - the European single market – Monetary union - the single currency, the euro
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1951 1957 1960 1966
July 23, 1951. Treaty of Paris
is signed creating the European Coal and Steel Community
(ECSC). W.Germany, France, Italy,Belgium, The Netherlands,
Luxembourg (the Six)
January 1, 1957Treaty of Rome
creates the European Economic Community(EEC) and Euratom,
The European AtomicEnergy Agency.
Membership – The Six
European FeeTrade Assoc
(EFTA) formed
ECSC, EEC andEuratommerged formingthe EC
Luxembourgcompromise
1965
EMU TIME-LINE - 1
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1973 1979 1981 1986
The UK, Ireland and Denmark accede to
the EC. Norwayvotes ‘NO’ in a
popular referendum
The European Monetary System
(EMS) is established. Itlaunches theEuropean
Currency Unit (the ECU) - thepredecessor of
the euro.
Greece accedes
to the EC
The White Paperpublished, setting
out measuresnecessary for the completion of the‘single’ market
• The SingleEuropean
Act* signed
• Spain &Portugal accede tothe EC
1985
EMU TIME-LINE - 2
* Takes effect July 1, 1987
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1989 1990 1991 1992 1994 1995
Delors Reportpublished.
Blueprint forMonetary
Union
July 1990Preparations
for Monetary
Union begin
Maastricht TreatySigned. Establishes
EU composed ofthe EC along withcommon security/foreign policy andcommon internal
affairs policy
Dec 31, 1992Single Market
Program completed
• SingleMarket Program
extended toEFTA
membersnot in the EU
• EuropeanMonetary Institute
established inFrankfurt
EMU TIME-LINE - 3
FinlandSweden
& Austriaaccedeto theEU
THE EU-15
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Dimensions of economic integration
Free tradebetweenmember
states
Commonexternal
tariff
Free movement of
factors ofproduction
Harmoni-zation
of economicpolicy
Free tradearea
Customs union
Commonmarket
EMU
Centralizationof economic
and monetary policy
YES NO NO NO NO
YES YES NO NO NO
YES YES YES YES NO
YES YES YES YES YES
Outputs Inputs Policy
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Structure of the EU
• Council of Ministers– members of national executives
• European Commission and its commissioners (the EU civil service)– appointed by national executives– national quotas for portfolios
• European Parliament - elected, but with limited power
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Common Agriculture Policy - CAP• Enshrined in the Treaty of Rome, it reflected the
post-war fears regarding food security• Grew over time to become the largest EU budget
item with significant wealth transfer• Made up of (a) tariffs (b) export subsidies and (c)
direct payments to farmers• Enabled the EU to become a significant exporter• Recent attempts at reform
– MacSharry Reforms (1992) - gradual approach– Agenda 2000 - replacing intervention in agriculture with
regional development payments
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Competition Policy
• Implemented by Directorate General IV of the European Commission
• Competition and antitrust policies appear in Articles 85-94 of the Treaty of Rome
• Aim is to ensure that ‘competition in the common market is not distorted’.
• Reinforced in the SEA*.
• But, policy is only as good as its implementation. *Single European Act
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Competition Policy - Implementation
• Most targets have been non-EU companies, e.g., Philip Morris (US), Continental Can (US), Tetra Pak (Swiss)
• EU companies are often exempted on grounds of ‘generating competitiveness’– Block exemptions in technology sectors– E.g., Alcatel Espace (France) and ANT
Nachrichten (Germany)
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The Social Chapter• Amends the Treaty of Rome, signed 1991
• Covers– improving work environment for health/safety– working conditions– information and consultation w/ workers– employee representation– social security– protection against dismissal– gender equality– integration of persons excluded from the labor market
• All EU countries except the UK that has an opt-out
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MONETARY UNIONWelcome to Euroland*
*Not to be confused with Eurodisney
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Precursors• Monetary union - hinted at in the Treaty of
Rome
• The Werner Report of 1969 begins the period of monetary coordination
• Leads to the European Monetary System of exchange rate parity and the ECU in 1979– The ECU - artificial currency unit similar to the SDR
• European Monetary Institute (Frankfurt) established 1994, precursor to European Central Bank
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COMPOSITION OF THE ECU*
CURRENCYDeutsch markFrench Franc
SterlingLira
GuilderBelgian Franc
Lux FrancPeseta
Danish KroneIrish Punt
Gr. DrachmaPort. Escudo
AMOUNT0.624201.332000.08784151.8000.219803.301000.130006.885000.197600.008551.440001.39300
WEIGHT (%)30.119.013.010.29.47.60.35.32.41.10.80.8
*Prior to 1995
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THE EU 15 on January 1, 1999
IN Euroland Austria, Belgium, Finland, France, Germany,
Ireland, Italy, Luxembourg, The Netherlands, Portugal, Spain (11)
OUT of Euroland The UK, Sweden and Denmark were invited
to join, but declined (3) Greece wished to join, but was not invited (1)
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Monetary Union Time-line
July1990
Jan 1 1999
Dec 312001
Jan 12002
July 12002
Preparationperiod
PHASE BDual legal
tenderperiod
• The preparation period was to be used to set up systems in the public and private sectors to ensure a smooth changeover.• During Phase B, the euro is introduced into the securities marketsand for non-cash transactions. No currency is yet in circulation.• Euro currency appears in circulation on Jan 1, 2002.• The old currencies of the Euroland countries cease to be legaltender on July 1, 2002.
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The Future• The biggest single issue confronting EMU -
expansion• May 2004, 10 entrants - the Czech Republic, Hungary,
Slovenia, Cyprus, Malta, Estonia, Poland, Lithuania, Estonia, Latvia
The EU 15
The EU 25
US$ 23,500
Per capita GDP* Growth Rate*
1%
US$ 20,836 1.7%
370 million
Population
454 million
* 2002 data
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Challenges
• Stresses on the both the economic and monetary sides of the EMU– Poland and CAP– monetary policy with wider regional disparities
• Down the road - Turkey? Ukraine?
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EXCHANGE RATE REGIMES
Money and trade
Money must be round so it circulate and flat so it can accumulate.
Geoffrey Crowther
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Exchange rate regimes• Intrinsic money: No exchange rates
were necessary• Representative money: Each country
had to define the value of its currency in terms of other currencies
• Two regimes– Fixed exchange rates - 1880s - 1973
– Floating exchange rates - 1973 till the present
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The Gold Standard
• Initially, all currencies were defined in terms of precious metals - gold and silver
• By the end of the 19th century, bi-metallism, (usage of both gold and silver as standards), disappeared and most countries settled on a common standard using gold
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Accession to the Gold StandardGermany 1871
Scandinavia* 1874Denmark 1875
Norway 1875Sweden 1875Holland 1875Belgium 1873Italy 1873Switzerland 1873France 1876Spain 1876Austria 1879Russia 1893India 1898
USA (officially) 1900* Date of currency union
• The Gold Standard wasthe means of establishing exchange from the 1880still 1939
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Exchange Rates under the Gold Standard
• $1 = 22.5 grains of gold
• GBP 1 = 113 grains of gold
• Therefore GBP 1 = $5.02
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Pressures on the Gold Standard• Instability of the 1920s
– German hyperinflation– US boom – ‘the roaring twenties’– UK instability – the General Strike 1926
• The Great Depression, 1929 – – Trade wars prior to and caused by it– Smoot-Hawley Act saw US tariffs rise from 16% in
1920 to nearly 60% in 1932• Countries tried to maintain falling currency values
by stockpiling and acquiring gold reserves• Economies were artificially constrained by the
availability of a gold.
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The Gold Standard – R.I.P.
The fundamental problem with the Gold Standard was that it related the value of money to gold, rather than to the underlying economy.
It formally ended with the cessation of normal trading activities caused by World War II.
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Replacing gold
• There was the widespread perception that economic failures had played a major role in causing the WWII.
• The Gold Standard was seen as a problem
• Some dreamed of a universal currency
• The UK and US Treasuries proposed a supranational monetary authority
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The end of fixed exchange rates• The Bretton Woods ‘paper standard’ collapsed
because the US$ became weakened on the F/X markets by continuous US trade deficits.
• It was replaced by a system of floating exchange rates.– Floating exchange rates are increasingly determined by
market forces (trade and capital flows) though there are continuous attempts by governments to manage them.
– Various worldwide attempts at currency alignments.
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Summary so far:Exchange rate time-line
Fixed exchange rates Floating exchange rates
1880s 1939 1944 1973
Gold Standard
Bretton WoodsAgreement
PaperStandard
• Free float• ‘Pegged’ float• Currency boards
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Exchange rates – bottom line• For over a century, governments have tried
to set fixed exchange rates• These strenuous attempts have met with, at
best, limited success• When exchange rates are fixed, adjustments
to real shocks must be borne by other macroeconomic variables– Money side: Interest rates, inflation rates, etc.– Real side: Unemployment rates, tax rates,
government spending
Ram Mudambi / Temple U and U of Reading 38
Optimum currency areas - theory
• The theory is due to Robert Mundell• Costs of a single currency –
– loss of flexible exchange rates to correct trade imbalances
– real sector adjustments are necessary
• Benefits of a single currency – Lower transaction costs
• In an optimum currency areaCosts < Benefits
Ram Mudambi / Temple U and U of Reading 39
Effects of currency union
• Removal of intra-union currency uncertainty and lower transaction costs
BUT
• Member states lose control of monetary policy
• Main policy instruments that are lost:– Money supply– Interest rates
Ram Mudambi / Temple U and U of Reading 40
Optimum currency areas –requirements
• The basic implication is that in optimum currency areas
– the need for real exchange rate dynamics is low
– it is possible to make policy corrections in response to macroeconomic shocks
Ram Mudambi / Temple U and U of Reading 41
Low exchange rate dynamics
1. High factor mobility – labor and capital
2. Similar sectoral economic structure
3. Similar pattern of business cycles
4. Price and wage flexibility
5. Similar inflation rates
6. Diversified product markets
7. High relative level of intra-area trade
Ram Mudambi / Temple U and U of Reading 43
Policy tools
1. Fiscal integration: Fiscal transfers from one region to another to offset the effects of divergent shocks
2. Policy integration: Similar monetary and fiscal priorities
3. Similar levels of economic development, so that fiscal transfers are not excessive
Ram Mudambi / Temple U and U of Reading 44
THE MACROECONOMICS OF CURRENCY UNION
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The EU - an optimum currency area?
• Intra-EU labor mobility – poor
• Business cycles – – ‘the DM club’ of Germany, Austria and Benelux
are convergent; the UK follows the US cycle
• Wage and labor market flexibility – poor
• Inflation rates – North vs. South
• Intra-EU trade – Benelux > 60%, Spain 17%, EU average 35%.
Ram Mudambi / Temple U and U of Reading 46
Implications• There is a single monetary ‘one size fits all’
monetary policy’• In practice this will be set for the major EU
economies – Germany, France, Italy• As countries find themselves in affected
differently by real shocks, policy that is right for some will be wrong for others
• Interest rates and exchange rates are no longer available as automatic stablizers
Ram Mudambi / Temple U and U of Reading 47
Example 1
• In 1999, demand in major EU economies was weak, so European Central Bank (ECB) policy was relatively expansionary
• In Spain and Ireland demand was strong, so that ECB policy caused a substantial increase their inflation rates, threatening their competitiveness
• If the scenario is reversed, they would see considerable increases in unemployment
Ram Mudambi / Temple U and U of Reading 48
Example 2
• The past 15 months have seen a substantial rise in the price of oil
• For EU heartland countries this is a negative shock as they are major oil importers
• For the UK, the effects are mixed, since it is a net oil exporter
Ram Mudambi / Temple U and U of Reading 49
Example 3
Output variability
Pri
ceV
aria
bili
ty
Floatingexchange rates
EMU
0
Variabilitymeasured bystandard deviation
Simulating the EU economy using the Liverpool model
Ram Mudambi / Temple U and U of Reading 50
The lure of the US model ...
• It must be borne in mind that in the US, regional shocks lead to – Substantial wage adjustment– Labor migration (e.g., California in 1991)– Fiscal offsets (lower regional income means
lower federal tax liability)• The fiscal offset has been estimated at 30% in the
US compared to 1% in the EU
Ram Mudambi / Temple U and U of Reading 51
But the Italian model is probably more realistic
• Structural differences between the North and the Southern ‘mezzogiorno’
• Single currency (lira) prevents devaluation and interest rate adjustment in the South
• Together with poor wage flexibility this implies – a high Southern unemployment rate– widening disparity between North and South– huge fiscal transfers from North to South
Ram Mudambi / Temple U and U of Reading 52
THE UNDERPINNINGS OF THE EURO:
ECONOMICS VS. POLITICS
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Euro launch criteriaThe Maastricht Treaty convergence criteria (EU
members wishing to participate in the euro)
• Government deficit / GDP < 3% • Government debt / GDP < 60%• Long-term interest rates < I + 2% *• Inflation rate < RPI + 1.5% **• Exchange rate in ERM band at least 2 years prior
to 1999• Central bank must be independent prior to 1999
* I = average long-term interest rate in 3 EU states with lowest rates** RPI = inflation rate in 3 EU states with lowest rates
Ram Mudambi / Temple U and U of Reading 54
Economics vs. politics• “Window-dressing” of national accounts in
1997-99 to meet the criteria – Italy (debt, deficit), Belgium (debt)– Interest rate convergence forced by national
central banks, prolonging recessions (Italy, France, Germany)
• ERM exchange-rate bands were widened • Article 104c of the treaty allows for criteria
adjustments in “… exceptional and temporary circumstances…”
Ram Mudambi / Temple U and U of Reading 55
European Central Bank Policy - 1
• The ECB in Frankfurt was originally modeled on the German Bundesbank– The Bundesbank always maintained a target
growth rate for the money supply– The Bank of England has maintained an
inflation target
• ‘The ECB appears to target both’ – Martin Feldstein, former Chairman, US CEA
Ram Mudambi / Temple U and U of Reading 56
ECB Policy - 2• Confusion about ECB policy on financial markets
is compounded by– Conflicting ECB board member statements
– Secrecy of its deliberations
• Concerns about ECB discipline since the deutsch-mark can no longer be used as a benchmark
• The French opposition to ECB independence and insistence on the appointment of Jean-Claude Trichet as successor to Wim F. Duisenberg
• The effects on the euro have been predictable
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The euro – a longer view
0.70
0.80
0.90
1.00
1.10
1.20
1.30
1.40
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
(Dollars per euro) $ Denominated Imports Cheaper
$ Denominated Exports More Expensive