lecture 4, december 2nd macroeconomics, foreign trade and the european union. basics and examples

Lecture 4, December 2nd

Macroeconomics, foreign trade and the European Union. Basics

and Examples.

Macroeconomics, foreign trade and European Union. Basics.

In 1991 in the Maastricht treaties to the European Union, it was also decided, to implement a European Currency. The Euro.• since the end of the Bretton Woods System in 1971European countries decided to fix their currencies to each other• An artificial European counting currency, the ECU, was implemented• As Germany was the economically strongest country after some time the Deutsche Mark got an anchor currency of this system

Lecture 4Dipl.- Kfm. Thomas Stiegler, University of Göttingen.2

A short history of the EURO (1)


• The Deutsche Bundesbank got the leading central bank in the system having the power to decide about monetary policy in EC• Besides that economical power, Germany gained, in 1990 Germany was reunified. So especially France among others were frightened about a to powerful Germany in Europe. However to reunify Germany the 4 winners of 2nd World War would have to accept that.




• As France was one of these four powers, Francois Mitterand connected these two points: his condition for reunification was that the Germans accept to create the Euro and thus loose their power over European monetary policy• as agreed in Maastricht treaties in 1999 the Euro started.That means the decision to implement a Euro was a political but not lead by economic reasons. That is why we will have a look at theory next.




• Mundell first in 1961 published about OCA. In the following his work was widened and so today we

usually take four main points to recognize an OCA:1. Labor mobility across the area;2. Capital mobility, price and wage flexibility over the region3. Fiscal responsibility of members for each other4. Similar business cycles and general economic situation


The optimal currency area (OCA)


• Nobody in European Union needs a visa to work in another country, you can move everywhere• There are a lot of different languages and cultures in Europe making mobility difficult, especially for low educated people

Evidence from European reality shows, that labor mobility is at a quite low level in Europe overall.


Is the European Union an OCA? First point.


• There are no capital movement restrictions between EU states• The biggest amount of foreign trade of EU states is between each other. More than 60% is traded inside Euro area.• Wages are still subject to national decisions, as well as working laws, retirement ages and so onWages nowhere really seem to be flexible, even in national states like the US, so in this case we can say, EU is quite an OCA


Is the European Union an OCA? second point.


• in the Maastricht treaties there is a no bail-out clause. No country has to pay for another’s dept. • Instead of responsibility for each other’s dept there are rules for convergence of macroeconomic situation. The so called Maastricht criteria (will be explained later)• In the crisis de facto there was a bail out for IRE and GR

So in this case EU recognized mechanisms are necessary, and implemented some. However through the crisis there was a bail-out so far for Greece and Ireland.


Is the European Union an OCA? third point.


• In Europe countries are dependent on very heterogenious goods, so there is the danger of asymmetric shocks.• Through eastern enlargement the business cycles got even more heterogeneous, as states in Eastern Europe are still Emerging markets and thus grow very different from highly developed industry states • Even in “old” EU differences between north and south are big.A very critical point, as it is one of the most important! The Central Bank can only implement ONE monetary policy, so there can be disadvantages for countries.


Is the European Union an OCA? fourth point.


• As we saw, if there should be an economical rational currency union in Europe some synchronization is necessary.• There are four main criteria, the so called Maastricht criteria, a country needs to meet them to join:1. governmental debt 2. inflation rates3. exchange rates4. long-term interest rates


The Maastricht criteria. An attempt to create unity


• to the first point: A country is not allowed to have a debt for more than 3% of the GDP, the overall debt of a country may not exceed 60% of GDP• to the second point: the inflation rate over the last 3 years is not more than 1.5% above the average rate of the 3 countries having the lowest inflation rate.• The currency of a country to join is stable in it’s exchange rate for at least 2 years.




• the interest rates are not more than 2% higher than in the 3 countries with the lowest inflation rate for the last 3 years.

If these criteria are realized an acceptable situation would occur. So argued a lot of politicians, but also economists. However there is a big problem:• There are no mechanisms how to punish countries not meeting these criteria anymore AFTER joining currency union

Problem: countries can try to meet the criteria to join and then continue like before!




• the interest rates are not more than 2% higher than in the 3 countries with the lowest inflation rate for the last 3 years.

If these criteria are realized an acceptable situation would occur. So argued a lot of politicians, but also economists. However there is a big problem:• There are no mechanisms how to punish countries not meeting these criteria anymore AFTER joining currency union

Problem: countries can try to meet the criteria to join and then continue like before!


Evidence from reality….


• The Euro started at a trust level of currencies like the Deutsche Mark, or Austrian Schilling, Dutch Guilder.• As a consequence, the interest rates for credits in the Euro zone were at the level of the German interest rates• Before countries like Portugal, Greece or even Spain and Italy had to pay higher rates, as of the higher risk


… and that is what happened.


• The interest rates to pay the interest on the national debt went down, so serving the debt accounted to a smaller part of national budgets.• It was meant that the gained money is used to decrease the overall debt• However, states optimized at another stage: the interest payments in the budget were kept constant! Meaning: overall debt was highly increased


… and that is what happened.


• As the in history of economy no state so far went bankrupt, many banks, especially from Europe lended money to these states, as it was seen as a save investment• as of the big capital market these countries had easy access to any credit desired. • Through this behavior another problem occurred as well: Savings from the north were transferred to the south. The interest rates for northern firms thus went up highly.


But who lended that money?


• As said above there were no mechanisms to punish states not meeting the criteria anymore. Those which existed were erased.• The markets gave the money to countries, which they knew are going into debt to far• So there was no pressure to really change the economical behavior in southern Europe.


Missing pressure from the EU AND the markets


• Overall productivity in the south is lower than in the north, but wages are not much lower (different situation in Eastern Europe!)• Thus the production costs are raising through raising wages, leading to a lower competitiveness of southern European goods on northern markets• Through this development southern European states usually had higher inflation rates before the Euro


The „southern European approach“ before Euro (1)


• So to keep in challenge with the northern states, the countries of the south devaluated their currency quite regularly. To illustrate: 1959 1000 Italian Lira were 6,732 DM, 1995 0,8814 DM• To enter Euro these states worked hard to change their macroeconomic indicators. Because to enter they are reviewed very strictly


The „southern European approach“ before Euro (2)


• as described above the states of the south fell back into deep debt as control mechanisms fell apart• The states kept their wage/price behavior, meaning high inflation rates even in Euro times.• Southern Europe lost competitiveness. Negative trade balances. Loosing market shares


Falling back in old behavior…


• As through the financial crisis, there was a big negative external effect on southern European countries, and money flows from the north stopped the problem became visible• As investments in non competitive economies isn’t

attractive, when markets go short in capital, states of the south get into trouble in serving their debt.• Markets see the danger and take higher interest rates, which makes the situation even worse


Crisis is the brought problems to the light.


• Northern states help the southern states out of a crisis which was only possible with the lent money of their savers.• The Euro will survive, as it is backed by a lot of real

economic power of states, which are not that bad in debt.• The actual problem is made worse through speculation from the US and UK against Euro. USA and UK are DEEPER in debt than Portugal or Greece. Spain and Italy are even “better off” than these two


The end of the day...


• As we saw in the beginning it was a political decision to have the Euro. It is not backed by economy• The different economical approaches in European region make it hardly possible to have a common good monetary policy.• Politicians say: if the Euro fails, the EU fails. And are going on the political trip again…


The Euro - a great story?


• There are regions in Europe which fit the OCA definitions much better: states at the Mediterranean Sea, Northern European states and Middle Eastern European states. Why not to have 3 Euros? • biggest problem: France. France is an important country in Euro zone. However it walks both ways. The southern and the northern.


A proposal as a perspective.

lecture 4, december 2nd macroeconomics, foreign trade and the european union. basics and examples

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