Theorie und Politik der Europ

1
Theorie und Politik der Europäischen
Integration
Theory and Politics of European Integration

• Lecture 7
• The EURO and Optimal Currency Area Theory
• Fiscal Policy and the Stability Pact

Prof. Dr. Herbert Brücker
2
Exam

• Topics
• Microeconomics of Trade
• Preferential Trade Liberalization
• Scale Economies (BECOMP diagram)
• Trade and Competition Policies
• Dynamics of integration
• Capital and labour mobility
• Macroeconomics of monetary integration
• Optimum Currency Area Theory
• European Monetary Union and Eurocrisis (next
  lecture)

3
The last Lecture

• A Primer to International Macroeconomics and
  Exchange Rate Policies
• The long-term neutrality of money in the AS-AD
  Diagram
• Fiscal Policy in the IS-LM Diagram
• Monetary Policy in the IS-LM Diagram
• The trade-off between fiscal and monetary
  policies
• A Monetary History of Europe
• The Gold Standard
• Humes Mechanism Monetary Equilbrium under the
  Gold Standard
• The Interwar Period
• The Bretton Woods System
• The Snake and the Super-Snake
• The EURO

4
This Lecture

• Optimum Currency Area (OCA) Theory
• What are the trade-offs?
• Asymmetric shocks and currency areas
• Criteria for an optimal currency area
• The European Monetary Union (EMU)
• Maastricht Treaty and History
• The Eurosystem
• Objectives, instruments and strategy
• The record during the first years

5
This Lecture

• Fiscal Policy and the Stability Pact
• Fiscal policy in the monetary union
• More and more important?
• Borrowing instead of transfers
• Automatic stabilizers and discretionary policy
  actions
• Fiscal policy externalities
• Spillovers and coordination
• Cyclical income spillovers
• Borrowing cost spillovers
• Excessive deficit and the no-bailout clause
• Collective discipline

6
Reading

• Richard Baldwin/Charles Wyplosz, The Economics of
  European Integration, 3rd Edition, 2009, Ch. 11
  (Optimum Currency Areas) and Ch. 18 (Fiscal and
  Stability Pact)

7
A good question, no simple answer

• Should curreny area borders coincide with
  national borders?
• If not, how best to delineate currency areas?
• What economic criteria should be used?

8
The economic toolkit

• There must be benefits and costs involved
  in adopting a common currency
• The solution has to involve trading off
  these benefits

9
In a nutshell

• The benefits
• Money exhibits increasing returns to scale
  (network externalities)
• E.g. you save transaction costs for money
  exchange the people use your currency
• The world is the way to maximize these benefits
• The costs
• Loss of monetary and exchange rate instruments
• Matters in presence of
• Price and wage stickiness
• Asymmetric shocks

10
Focusing on costs

• Start with the idea that benefits argue for one
  worldwide currency
• Ask why not
• Look at the costs
• No precise way of estimating costs and benefits
  so, in the end, a matter of judgement
• Look at asymmetric costs
• How they create trouble
• What makes them more likely
• What makes them less painful

11
Asymmetric shocks

• Simplest example an adverse demand shock
  how can the exchange rate help?
• Assumption sticky prices and wages
• Definition of exchange rate
• EP/P
• or in terms of wages
• E W/W

12
Asymmetric shocks

• Simplest example an adverse demand shock
  how can the exchange rate help?

If domestic prices and wages are sticky, adverse
demand shock will reduce production to C if
exchange rate does not adjust
13
Asymmetric shocks

• Simplest example an adverse demand shock
  how can the exchange rate help?

If exchange rate adjusts, production declines to
D.
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Asymmetric shocks adverse demand shock in 2
country CU
15
Asymmetric shocks adverse demand shock in 2
country CU
No currency union caseReal exchange rate
declines in country A to ?1, production declines
to B, country B remains unaffected. What would
happen if exchange rate stays at ?0?
16
Asymmetric shocks adverse demand shock in 2
country CU
No currency union caseReal exchange rate
declines in country A to ?1, production declines
to B, country B remains unaffected. What would
happen if exchange rate stays at ?0?
17
Asymmetric shocks adverse demand shock in 2
country CU
Currency union caseCentral Bank let currency
decline to ?2. production declines in country A
to C, in country B to D, and excess demand
creates inflationary pressure D-D.
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Asymmetric shocks adverse demand shock in 2
country CU
Disequilbria dont last forever. In country A
wages and prices decline, such that production
moves to equilibrium point B. In country B wages
and prices will increase, until economy is back
to point A as well.
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Implications of asymmetric shocks

• Thus, both countries are hurt when they share
  the same currency
• Also the case when a symmetric shock creates
  asymmetric effects
• This is an unavoidable cost of a currency area

20
Six critieria for a optimal currency area

• Next questions
• What reduces the incidence of asymmetric shocks?
• What makes it easier to cope with shocks when
  they occur
• The analysis develops six criteria for an
  optimal currency area (OCA)
• Three economic
• labour mobility
• diversion
• trade openness
• Three political
• transfers
• homogeneous preferences
• Common destiny

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Criterion 1 (Mundell) Labour mobility

• In an OCA labour moves easily across national
  borders.
• Caveats
• Labour mobility is easy within national borders
  (culture, language, legislation, welfare, etc),
  but much less so across national borders
• Capital mobility difference between financial
  and physical capital
• In case of country specialization, skills also
  matter and hinder labour mobility

22
Asymmetric shocks adverse demand shock in 2
country CU

• What happens with labour mobility?
• Assume exchange rate declines to ?2 and
  production is at B in country 1 and D in country
  2.

23
Asymmetric shocks adverse demand shock in 2
country CU

• Labour mobility shifts supply curve leftwards in
  country 1 to S and rightswards in country 2 to
  S.
• New equilbrium ar C and D.
• Output gap is zero.

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Criterion 2 (Kenen) Production diversification

• Countries whose production and exports are widely
  diversified and of similar structure form an OCA.
  
• Indeed, in that case, there are few asymmetric
  shocks and each of them is likely to be of small
  concern

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Criterion 3 (McKinnon) Openness

• Countries which are very open to trade and trade
  heavily with each other form an OCA.
• Distinguish between traded and non-traded goods
• Traded good prices are set worldwide
• A small economy is price-taker, so the exchange
  rate does not affect competitiveness
• In the limit, if all goods are traded, domestic
  good prices must be flexible and the exchange
  rate does not matter for competitiveness

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Criterion 4 Fiscal transfers

• Countries that agree to compensate each other for
  adverse shock form an OCA.
• Transfers can act as an insurance that mitigates
  the costs of an asymmetric shock
• Transfers exist within national borders
• Implicitly through the welfare system (e.g.
  unemployment benefits)
• Explicitly in federal states

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Criterion 5 Homogeneous preferences

• Countries that share a wide consensus on the way
  to deal with shocks form an OCA.
• Matters primarily for symmetric shocks
• Prevalent when the Kenen criterion is satisfied
• Do countries agree how to adress symmetric
  shocks? Should we favour exporters (currency
  depreciation) or consumers (currency
  appreciation)? How much?
• May also help for asymmetric shocks
• Better understanding of partners actions
• Encourages transfers

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Criterion 6 Commonality of destiny

• Countries that view themselves as sharing a
  common destiny better accept the costs of
  operating an OCA.
• A common currency will always face occasional
  asymmetric shocks that result in temporary
  conflicts of interests
• This calls for accepting such economic costs in
  the name of a higher purpose
• Solidarity vs. Nationalism

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Is Europe an OCA?

• A synthetic OCA index
• How much of a currency appreciation/devaluation
  vis-à-vis the DM is needed to keep economic
  conditions unchanged?
• A ten year period is considered.
• Indicator for the relevance of adjustment
  pressures from asymmetric shocks.

30
Inside the OCA index Openness

• Most EU countries are very open The McKinnon
  criterion is broadly satisfied

31
Inside the OCA index Diversification

• Most EU countries have a diversified production
  structure (intra-industry trade dominates)
• The Kenen criterion is broadly satisfied and well
  explains which countries joined the euro area

32
Inside the OCA index Labour mobility (1)

• The labour mobility criterion cannot be
  black-and-white
• The migration response to economic incentives
  must consider many costs
• Moving costs
• Risk of becoming unemployed
• Longer run career opportunities
• Family prospects
• Eligibility to welfare
• Taxation
• Cultural/linguistic differences
• National attachment

33
Inside the OCA index Labour mobility (2)

• An international comparison suggests that labour
  mobility is low in Europe
• Across countries
• Even within countries

34
Inside the OCA index Labour mobility (3)

• Low labour mobility implies that unemployment
  bears much of the burden of adjustment to shocks
• An US-EU comparison
• How much of an initial employment shock is
  absorbed by labour mobility?

35
Inside the OCA index Transfers

• The EU does not satisfy the transfer criterion
• The overall EU budget
• is low, capped at 1.27 of EU GDP
• entirely used for administration, CAP, regional
  and structural funds
• These funds do not vary with the business cycle
  and are not earmarked to address asymmetric
  shocks
• This changes with the ESM/ESRM facilities in the
  course of the Eurocrisis

36
Inside the OCA index Homogeneity of preferences

• Preferences could affect the role of monetary and
  fiscal policies to address external shocks
• Little is known about this criterion
• Eurbarometer survey suggest that people agree on
  common decisionmaking for defence (64), but 67
  reject decisionmaking in the area of social
  affairs
• Eurocrisis show increasing tensions across
  nations and their populations and disagreement
  e.g. on fiscal transfers and macroeconomic
  policies

37
Inside the OCA index Commonality of destiny

• Little is known about this criterion
• Public opinion polls did not reveal deep
  opposition to EU institutions when EURO was
  introduced
• But support faded away in course of the EURO
  crisis
• Differences between the South and North of
  Europe, particularly between the crisis countries
  and Germany
• Criticism of the Troika

38
Summarizing
Criterion Satisfied?
Labour mobility No
Trade openness Yes
Product Diversification Yes
Fiscal transfers No (but tend to increase)
Homogeneity of preferences Partly (eroding?)
Commonality of destiny ?
39
Overall

• Is the OCA glass half full or half empty?

40
History never ends the endogeneity of OCA
criteria

• Living in a monetary union may help fulfill the
  OCA criteria over time
• Would the US be an OCA without a single common
  currency?
• Will the existence of the EURO area change
  matters too ?
• Will the Eurocrisis create further integration
  e.g. via fiscal transfers and common fiscal
  policies or further disintegration? Split between
  the South and the North?
• Will no-Eurozone members leave EU, e.g. UK?

41
Will trade deepen?

• Little evidence that reducing exchange rate
  volatiliy increases trade
• Mounting evidence that eliminating exchange
  rate volatility by adopting a common
  currency raises trade a lot
• Estimates range from 50 to 100
• The border effect provides similar estimates

42
Will diversification grow or decline?

• Argument 1 intra-industry trade will grow
• Argument 2 specialization will increase
• No firm conclusion so far

43
EMU and labour markets

• Mobility may not change much, but wages could
  become less sticky
• Two views
• The virtuous circle labour markets respond to
  enhanced competition by becoming more flexible
• The hardening view labour markets respond to
  enhanced competition by increasing protective
  measures that raise stickiness
• The jury is still out EURO crisis has not much
  increased labour mobility in 2010, but in 1st
  half year of 2013
• E.g. Greek migration in Germany 80.
• But Substantial diversion of migration flows
  from NMS equilibriate labour supply between
  crisis and non-crisis countries

44
Are the other criteria endogenous?

• Transfers
• No support for more taxes fo finance transfers at
  beginning of EMU
• But Meanwhile 50 of German population support
  at least some transfers to bailout Greece
• Homogeneity of preferences
• No presumption that it will change soon, but EURO
  crisis my force countries to do so (e.g. zero
  debt ceiling)
• Commonality of destiny
• No presumption that it will change soon, but EURO
  crisis my lead to contradicting forces

45
In the end

• Monetary union is not only about economics
• The OCA criteria do not send a clear signal
• The EU is not a perfect OCA
• A monetary union may function, at cost
• The OCA criteria tell us only partly where the
  costs will arise
• Labour markets and unemployment
• Political tensions in presence of deep asymmetric
  shocks
• Fiscal shocks and imbalances like real estate
  bubble remain largely unadressed

46
Fiscal Policy and the Stability Pact

• Fiscal Policy and the Stability Pact
• Fiscal policy in the monetary union
• More and more important?
• Borrowing instead of transfers
• Automatic stabilizers and discretionary policy
  actions
• Fiscal policy externalities
• Spillovers and coordination
• Cyclical income spillovers
• Borrowing cost spillovers
• Excessive deficit and the no-bailout clause
• Collective discipline

47
The fiscal policy instrument

• In a monetary union, the fiscal instrument
  assumes greater importance
• The only macroeconomic policy instrument left at
  the national level
• Its effectiveness is increased (a result from the
  Mundell-Fleming model)
• Heavily used in 2008 financial crisis and
  subsequent period
• A subsitute to transfers
• Yet, many questions arise regarding its
  effectiveness and use

48
Limits on effectiveness

• The crucial role of private expectations
• A deficit today but a debt tomorrow who will
  pay?
• A tax cut, but how permanent?
• Slow implementation
• Agreement within government
• Agreement within parliament
• Spending carried out by bureaucracy
• Taxes not retroactive
• Result countercyclical moves can become
  procyclical actions and in extreme cases create
  fiscal crisis (default of government bonds)

49
A crucial distinction automatic vs. discretionary

• Automatic stabilizers
• Tax receipts decline when the economy slows down,
  and conversely
• Welfare spending rise when the economy slows
  down, and conversely
• No decision, no lag nicely countercyclical
• Rule of thumb deficit worsen by 0.5 of GDP when
  GDP growth declines by 1

50
Public debt and automatic stabilizers in Europe
51
A crucial distinction automatic vs.
discretionary

• Discretionary actions a voluntary decision to
  change tax rates or spending
• Technically a change in the structural budget
  balance
• But no automatic correction of deficits, so a
  problem of discipline

52
Should instrument be subject to some form of
collective control?

• Yes, if national fiscal policies are a source of
  several externalities
• (Positive) income externalities via trade
• Important and strengthened by monetary union
• A case for some coordination
• Borrowing cost externalities
• One common interest rate
• But EURO area integrated in world financial
  markets
• Sovereign debt default risk put other EMU
  members or ECB under bail-out pressure

53
Income spillovers, 1972 -2005
54
What is the problem with the deficit bias?

• The track record is not really good (2005
  2013)

• Quelle OECD STAT Database, 2013 eigene
  Berechnungen.

55
What is the problem with the deficit bias?

• The track record is not really good (2005
  2013)

• Quelle OECD STAT Database, 2013 eigene
  Berechnungen.

56
What is the problem with the deficit bias?

• Fiscal indiscipline in parts of the EURO area
  might concern financial markets and
• Raise borrowing costs for all countries
  unlikely, markets can distinguish among
  countries
• More serious is the risk of sovereign debt
  default in one member country
• capital outflows and a weak EURO
• pressure on other governments to help out
• pressure on the Eurosystem (European Central
  Bank) to help out

57
The answer to default risk the no bailout clause

• The no-bailout clause
• Overdraft facilities or any other type of credit
  facility with the ECB or with the central banks
  of the Member States (hereinafter referred to as
  national central banks) in favour of Community
  institutions or bodies, central governments,
  regional, local or other public authorities,
  other bodies governed by public law, or public
  undertakings of Member States shall be
  prohibited, as shall the purchase directly from
  them by the ECB or national central banks of debt
  instruments. (Art. 101)

58
The answer to default risk the no bailout clause

• The no-bailout clause Question of credibility
• Ex post the world looks different See the
  Draghi-statement of the ECB on debt default
• Thus, fears remain
• Informal pressure
• Impact on EURO
• Prevention is better, especially given a
  tradition of indiscipline

59
In the end, should fiscal policy independence be
limited?

• The arguments for
• Serious externalities
• A bad track record, anyway
• The arguments against
• The only remaining macroeconomic instrument
• National governments know better the home scene

60
The general principles

• Two general arguments for collective action
• Externalities
• Increasing returns
• Two general arguments against collective action
• Heterogeneity of preferences
• Information asymmetries
• And a caveat
• Governments may pursue own interests

61
How to restrain fiscal policies?

• Distinction No.1
• Micro/structural aspects (tax and spending levels
  and structure)
• Macro aspects (the balance between tax revenues
  and spending)
• Distinction No.2
• Coordination voluntary and flexible efforts at
  taking into account each others action
• Binding commitments or rules

62
The Stability and Growth Pact

• Formally, the implementation of the Excessive
  Deficit Procedure (EDP) mandated by the
  Maastricht Treaty
• The EDP aims at preventing a relapse into fiscal
  indiscipline following entry in euro area
• The EDP makes permanent the 3 deficit and 60
  debt ceilings and foresees fines
• The Pact codifies and formalizes the EDP

63
How the Pact works

• Emphasis on the 3 deficit ceiling
• Recognition that the budget balance worsens with
  recessions
• Exceptional circumstances when GDP falls by 2 or
  more automatic suspension of the EDP
• When GDP falls by more than 0.75, country may
  apply for suspension
• Precise procedure that goes from warnings to
  fining

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The procedure

• When the 3 ceiling is not respected
• The Commission submits a report to ECOFIN
• ECOFIN decides whether the deficit is excessive
• If so, ECOFIN issues recommendations with an
  associated deadline
• The country must then take corrective action
• Failure to do so and return the deficit below 3
  triggers a recommendation by the Commission
• ECOFIN decides whether to impose a fine
• The whole procedure takes about two years

65
The fine schedule

• The fine starts at 0.2 of GDP and rises by 0.1
  for each 1 of excess deficit

66
How is the fine levied

• The sum is retained from payments from the EU to
  the country (CAP, Structural and Cohesion Funds)
• The fine is imposed every year when the deficit
  exceeds 3
• The fine is initially considered as a deposit
• If the deficit is corrected within two years, the
  deposit is returned
• If it is not corrected within two years, the
  deposit is considered as a fine

67
The Broad Economic Policy Guidelines (BEPG)

• Emphasis on precautionary measures to avoid
  warnings and fines
• The stability programmes are embedded in the
  wider BEPG, a peer-monitoring process that
  includes the Lisbon strategy
• Each year, each country presents its planned
  budget for the next three years, along with its
  growth assumptions
• The Commission evaluates whether the submission
  is compatible with the Pact

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Issues raised by the Pact (1)

• The BEPG shift the focus to ex ante commitments
• Led to the Irish warning (2001)
• Decisions are taken by the ECOFIN, a political
  grouping
• France and Germany treated leniently in 2003-4
• Imposition of a fine can trigger deep resentment
• Are fines credible?
• If not, what is left?

69
Issues raised by the Pact (2)

• Does the Pact impose procyclical fiscal policies?
• Budgets deteriorate during economic slowdowns
• Reducing the deficit in a slowdown may further
  deepen the slowdown
• A fine both worsens the deficit and has a
  procyclical effect
• The solution a budget close to balance or in
  surplus in normal years

70
Issues raised by the Pact (3)

• What room left for fiscal policy?
• If budget in balance in normal years, plenty of
  room left for automatic stabilizers

71
Issues raised by the Pact (3)

• What room left for fiscal policy?
• If budget in balance in normal years, plenty of
  room left for automatic stabilizers

72
Issues raised by the Pact (3)

• What room left for fiscal policy?
• If budget in balance or surplus in normal years,
  plenty of room left for automatic stabilizers
• Some limited room left for discretion action
• In practice, the Pact encourages
• Aiming at surpluses
• Giving up discretionary policy
• At first glance, the early years seems to be
  hardest
• Takes time to bring budgets to surplus
• Today we know, it is even harder after a shock

73
The early years (before slowdown)
74
Further controversies

• Discipline imposed from outside
• A further erosion of sovereignty?
• Arbitrary limits
• Why 3?
• What about the debt celing of 60?
• Asymmetry
• The Pact binds in bad years only
• A budget forever close to balance or in surplus
  would drive debt/GDP ratio to 0

75
Final Lecture

• January 29, 2015