Joining a Monetary Union: Europes Great Monetary Experiment

1
Joining a Monetary Union Europes Great
Monetary Experiment

• Eduard Hochreiter
• Joint Vienna Institute
• Wilfrid Laurier University
• Thursday, September 27, 2007
• 3.00 p.m.

2
Overview

• Introduction
• A Look at History
• The Architecture of Maastricht incl Coordination
  of Macro Policies
• Benefits and Costs of Joining a MU
• Institutional Requirements for Joining EMU
• Economic Issues Regarding The Adoption of the
  Euro
• The Adoption of the Euro The Case of Greece
• Experiences with EMU
• Some general conclusions

3
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

4
2. European Integration Europes 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

5
2. European Integration Europes 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 Malta14th and 15th Euro
  Area-member
• 2009 Slovakia becomes the 16th Euro Area-member?

Back
6
Back
Back
Back
7
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.

8
3. The Architecture of the Maastricht Model - 2

• Amsterdam Treaty SGP
• SGP 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

9
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-specific
• Implies European Commission now more room for
  discretion and interpretation
• More symmetric ? consolidation in good times
• No EDP when G-deficit gt 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)

10
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, RD, 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!!)

Back
11
3. The Architecture of the Maastricht Model - 3

• 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

12
3. The Architecture of the Maastricht Model - 4

• 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?

13
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

Back
14
3. The Architecture of the Maastricht Model - 5

• (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.

15
3. The Architecture of the Maastricht Model - 6

• 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.

16
3. The Architecture of the Maastricht Model - 7

• 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!

17
3. The Architecture of the Maastricht Model - 8

• 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

18
3. The Architecture of the Maastricht Model - 9

• 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.

Back
19
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

20
4. Benefits and Costs of Joining a MU - 2 -

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

21
4. Benefits and Costs of Joining a MU - 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 gt 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

22
4. Benefits and Costs of Joining a MU - 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.

Back
23
5. Institutional Requirements of The Adoption of
the EuroThe 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

24
5. Institutional Requirements of The Adoption of
the EuroThe Maastricht Convergence Criteria - 2

• 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?
• 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?

25
Derivation of 3 deficit reference value
where d level of debt bp primary balance b
overall balance i nominal interest
rate r real interest rate rate of
inflation ge government expenditure g real
growth rate t taxes
Back
26
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 controversial
• 4. 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?

27
Accession Criteria - 1
Source European Commission
28
Accession Criteria - 2
Source European Commission
29
Accession Criteria - 3
Source European Commission
Back
30
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!

31
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

32
6. Economic Issues Regarding The Adoption of
the Euro - 3

• 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)

33
6. Economic Issues Regarding The Adoption of
the Euro - 4

• Entry into Time spent in ERM II
• New 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. gt 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

Back
34
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 lt20 to 120 of GDP
• average real growth 1 p.a.

35
7. The Adoption of the Euro The Case of Greece
- 2

• 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

36
7. The Adoption of the Euro The Case of Greece
- 3

• 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)

37
7. The Adoption of the Euro The Case of Greece
- 4

• Svensson test for Greece

Back
38
7. The Adoption of the Euro The Case of Greece
- 5

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

Back
39
7. The Adoption of the Euro The Case of Greece
- 6

• 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
  criterion 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.

40
The Impossible Trinity
Free Capital Movements
Let exchange rate float to maintain monetary
independence
Use monetary policy to maintain exchange rate peg
Independent Monetary Policy
Pegged Exchange Rate
Capital controls
Back
41
7. The Adoption of the Euro The Case of Greece
- 7
Back
42
7. The Adoption of the Euro The Case of Greece
- 8

• 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

Back
43
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)

Back
44
8. Experiences with EMU Growth convergence - 2 -
Back
45
8. Experiences with EMU- 3 -
Back
46
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.

47
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.

48
THE END

• THANK YOU
• FOR YOUR ATTENTION!