joining a monetary union: europe’s great monetary experiment

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Joining a Monetary Union: Europe’s Great Monetary Experiment

Eduard HochreiterJoint Vienna Institute

Wilfrid Laurier University

Thursday, September 27, 2007

3.00 p.m.

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Overview

1. Introduction2. A Look at History3. The Architecture of Maastricht incl

Coordination of Macro Policies4. Benefits and Costs of Joining a MU5. Institutional Requirements for Joining EMU6. Economic Issues Regarding The Adoption

of the Euro7. The Adoption of the Euro: The Case of Greece8. Experiences with EMU9. Some general conclusions

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1. 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

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2. European Integration – Europe’s 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

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2. European Integration – Europe’s 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 Malta:14th and 15th Euro Area-member

2009: Slovakia becomes the 16th Euro Area-member?Back

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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”.

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Amsterdam Treaty: SGPSGP 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

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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-specificImplies: European Commission now more room for discretion and interpretation+ More symmetric “consolidation in good times”+ No EDP when G-deficit > 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)

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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, R&D, 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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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

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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?

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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

ttytttt mbyitgb

)()(

)( yt yi

tb

tm

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(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.

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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.

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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!

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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

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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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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

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- 2 -

Costs:

Loss of monetary policy instrument Loss of seigniorage Higher real exchange rate persistence Cost of asymmetric shocks

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- 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: > + 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

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- 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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5. Institutional Requirements of The Adoption of the Euro:

The 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

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5. Institutional Requirements of The Adoption of the Euro:

The Maastricht Convergence Criteria - 2

1. 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?

1. 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?

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Derivation of 3% deficit reference value:

p

whered = level of debtbp = primary balanceb = overall balancei = nominal interest rater = real interest rate = rate of inflationge = government expenditureg = real growth ratet = taxes

p

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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 controversial4. 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?

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Accession Criteria - 1

Country

Government

deficit to GDP

Government debt to GDP

max 3.0% max. 3%

max. 60%

min. ERM II stay: 2 years max 6.4% NA NA NA NA

Denmark 2.10% -3.90% 30.0% 1-Jan-99 5.20% opt-out not yet set NA none yet

Sweden 1.50% -2.00% 50.9% 0 years 3.70% yes not yet set NA none yet

United Kingdom 2.20% 4.00% 42.2% 0 years 5.00% opt-out NA NA none yet

ERM II membership

sinceReference value (as of May 2007)

Convergence criteria Target date

Euro coins designInterest rate

Set by the country

Recommended by the

Commission

Obligation to adopt

Inflation rate

Government finances

Source: European Commission

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Country

Government

deficit to GDP


max 3.0% max. 3%

max. 60%


Bulgaria 4.60% -3.10% 29.9% 0 years 3.80% yes 2009-2010 NA in progress

Cyprus 2.00% 1.50% 65.3% 2-May-05 4.20% yes 1/1/2008 1/1/2008 ready

Czech Republic 2.20% 3.60% 30.4% 0 years 3.80% yes not yet set NA in progress

Denmark 2.10% -3.90% 30.0% 1-Jan-99 5.20% opt-out not yet set NA not yet

Estonia 4.30% -2.30% 4.5% 28-Jun-04 -4.10% yes 2010 To be announced ready

Hungary 3.50% 10.10% 61.7% 0 years 7.10% yes 2010-2014 NA in progress

Latvia 6.70% -0.10% 12.1% 2-May-05 3.90% yes 2010-2012 To be announced ready

Lithuania 2.70% 0.50% 19.7% 28-Jun-04 3.70% yes 2010 To be announced ready

Malta 2.20% 2.60% 66.5% 2-May-05 4.30% yes 1/1/2008 1/1/2008 ready

Poland 2.30% 3.70% 47.0% 0 years 4.25% yes 2012 NA in progress

Romania 4.00% 2.50% 20.3% 0 years 8.00% yes 2014 NA none yet

Slovakia 4.30% 3.10% 34.5% 28-Nov-05 4.30% yes 2009 To be announced ready

Euro coins

designInterest rate Set by the

country

Recommended by the

Commission

Obligation to adopt

ERM II membership



Inflation rate

Government finances


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Back

Country

Government

deficit to GDP


max 3.0% max. 3%

max. 60%


Croatia2.70% 2.20% 40.8% 0 years NA NA NA NA

Republic of Macedonia 3.20% 0.60% 39.5% 0 years NA NA NA NA

Turkey9.50% 0.60% 60.7% 0 years 10% NA NA NA NA

Albania2.40% 0 years NA NA NA NA

Bosnia and Herzegovina 0.90% 0 years NA NA NA NA

Serbia0 years NA NA NA NA

Montenegro 0 years NA NA NA NA

Euro coins

designInterest rate Set by

the country

Recommende

d by the

Commission

Obligation to adopt

ERM II membership



Inflation rate

Government finances


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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!

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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

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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)

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Entry into &Time spent in ERM IINew 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. > 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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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 <20% to ~ 120% of GDP average real growth ~1 % p.a.

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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

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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)

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Svensson test for Greece

Greek 10y-Interest Rate Bands Implied by Broad EMS Bands

0%

5%

10%

15%

20%

25%

1993

M1

1993

M6

1993

M11

1994

M4

1994

M9

1995

M2

1995

M7

1995

M12

1996

M5

1996

M10

1997

M3

1997

M8

1998

M1

1998

M6

1998

M11

1999

M4

1999

M9

2000

M2

2000

M7

2000

M12

GDR 10y max GDR 10y rate GDR 10y min

10

1

*1

ttt S

Sii

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March 16, 1998: Central rate: ECU/EUR 1 = GRD 353.109 January 17, 2000: New CR = GRD 340. 75 = Conversion rate

GRD/Euro(ECU)

300.00

310.00

320.00

330.00

340.00

350.00

360.00

01.0

1.1

998

01.0

3.1

998

01.0

5.1

998

01.0

7.1

998

01.0

9.1

998

01.1

1.1

998

01.0

1.1

999

01.0

3.1

999

01.0

5.1

999

01.0

7.1

999

01.0

9.1

999

01.1

1.1

999

01.0

1.2

000

01.0

3.2

000

01.0

5.2

000

01.0

7.2

000

01.0

9.2

000

01.1

1.2

000

01.0

1.2

001

GRD/Euro-Spot GRD-Central Rate

Introduction of the EuroERM I-entry

Revaluation

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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 cri

terion 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.

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The Impossible Trinity

Free Capital Movements

Pegged Exchange Rate

Independent Monetary Policy

Use monetary policy to maintain exchange rate peg

Let exchange rate floatto maintainmonetary independence

Capitalcontrols

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Three-Month Money Market-Spread(GRD minus DEM)

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

Jän.9

8

Mär.

98

Mai.9

8

Jul.9

8

Sep.9

8

Nov.9

8

Jän.9

9

Mär.

99

Mai.9

9

Jul.9

9

Sep.9

9

Nov.9

9

Jän.0

0

Mär.

00

Mai.0

0

Jul.0

0

Sep.0

0

Nov.0

0

Jän.0

1

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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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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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8. Experiences with EMU: Growth convergence

- 2 -

Back

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8. Experiences with EMU- 3 -

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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.

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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.

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THANK YOU

FOR YOUR ATTENTION!

joining a monetary union: europe’s great monetary experiment

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