Transcript Chapter 6 The Transition to a Monetary Union

Chapter 7:
The Transition to a Monetary Union
De Grauwe:
Economics of Monetary Union
The Maastricht Treaty
• The Maastricht Treaty was signed in 1991
• It is the blueprint for progress towards monetary
unification in Europe
• It is based on two principles:
– Gradualism: the transition towards monetary union
in Europe is seen as a gradual one
– Convergence criteria: entry into the union is made
conditional on satisfying convergence criteria
‘Convergence criteria'
For each candidate country:
(1) Inflation rate  average of three lowest
inflation rates in the group of candidate
countries + 1.5%
(2) Long-term interest rate  average observed
in the three low-inflation countries + 2%
(3) Joined the exchange rate mechanism of the
EMS and did not experience a devaluation
during the two years preceding the entrance
into EMU
(4) Government budget deficit  3% of its GDP
If this condition is not satisfied:
budget deficit should be declining
continuously and substantially and come
close to the 3%norm
or the deviation from the reference value
(3%) 'should be exceptional and temporary
and remain close to the reference value',
art. 104c(a))
(5) Government debt  60%of GDP
If this condition is not satisfied:
government debt should 'diminish
sufficiently and approach the reference
value (60%) at a satisfactory pace', art.
104c(b))
Why convergence requirements?
• The OCA theory stresses micro-economic
conditions for a successful monetary union
– Symmetry of shocks
– Labour market flexibility
– Labour mobility
• The Treaty stresses macro-economic
convergence
– Inflation
– Interest rates
– Budgetary policies
1. Inflation convergence
• Future monetary union could have an
inflationary bias
• The analysis is embedded in the Barro Gordon model
The inflation bias in a
monetary union
Inflation
Italy
EI
Germany
EG
U*
Un
Unemployment
•Before EMU Germany has low
inflation; Italy has high inflation
•Differences are due to different
preferences concerning inflation
and unemployment
•Once in the union, Germany
and Italy will decide together
•Inflation will reflect average
preferences and will be located
between EI and EG
• Germany looses welfare; Italy
gains welfare
• Germany wants evidence from
Italy that it has the same strong
preference for price stability
•Germany also wants ECB to be
clone of Bundesbank
2. Budgetary convergence
• Deficit and debt criteria can be rationalized in
a similar way
– A country with a high debt-to-GDP ratio has an
incentive to create surprise inflation
– The low debt country stands to lose and will insist
that the debt-to-GDP ratio of the highly indebted
country be reduced prior to entry into the
monetary union
– The high debt country must also reduce its
government budget deficit
• In addition, countries with a large debt face a
higher default risk
• Once in the union, this will increase the
pressure for a bailout in the event of a default
crisis
• No-bailout clause was incorporated into the
Maastricht Treaty
• But is this clause credible?
Numerical precision of budgetary
requirements is difficult to rationalize
• 3% and 60% budgetary norms have been
derived from formula determining budget deficit
needed to stabilize government debt:
d = gb
b = (steady state) level at which the government
debt is to be stabilized (in per cent of GDP)
g = growth rate of nominal GDP
d = government budget deficit (in per cent of GDP)
In order to stabilize the government debt at 60% of
GDP the budget deficit must be brought to 3% of
GDP if and only if the nominal growth rate of GDP is
5% (0.03 = 0.05 x 0.6)
Arbitrary nature of the rule
• The rule is quite arbitrary on two counts
– Why should the debt be stabilized at 60%?
• The only reason was that at the time of Maastricht Treaty
negotiation this was the average debt-to-GDP ratio in the
European Union
– The rule is conditioned on the future nominal
growth rate of GDP
• If the nominal growth of GDP increases above (declines
below) 5%, the budget deficit that stabilizes the
government debt at 60% increases above (declines
below) 3%
3. Exchange rate convergence
(no-devaluation requirement)
• It prevents countries from manipulating their
exchange rates
– e.g. so as to have more favorable (depreciated)
exchange rate in the union
• Note
– According to the Treaty, countries should maintain their
exchange rates within the 'normal' band of fluctuation (without
changing that band) during the two years preceding their
entry into the EMU
– Since August 1993, the 'normal' band within the EMS was 2
x 15%
– The exchange rate arrangements for the newcomers
(Denmark, Sweden, UK and accession countries) are similar
but not identical
4. Interest rate convergence
• Excessively large differences in the interest
rates prior to entry could lead to large capital
gains and losses at the moment of entry into
EMU
• However, these gains and losses are likely to
occur prior to entry because the market will
automatically lead to a convergence of long
term interest rates as soon as the political
decision is made to allow entry of the
candidate member country
How to fix the conversion rates
during the transition
• Madrid Council of 1995 implied that on 1
January 1999 one ECU would be converted
into one Euro
• At the same time the conversion rates of the
national currencies into the Euro had to be
equal to the market rates of these currencies
against the ECU at the close of the market on
31 December 1998
• This created potential for self-fulfilling
speculative movements of the exchange rates
prior to 31 December 1998
• The effect of such speculative movements
could be to permanently fix the wrong values
of the exchange rates
• In order to avoid this, the fixed rates at which
the currencies would be converted into each
other at the start of EMU were announced in
advance
– If these announcements were credible, the market
would smoothly drive the market rates towards the
announced fixed conversion rates
• This is exactly what happened. The authorities
announced the fixed bilateral conversion rates
in May 1998
• Transition was very smooth with minimal
turbulence
Table 6.1 Conversion rates of EMU currencies into the euro.
Belgian franc
Spanish peseta
Irish punt
Luxembourgish franc
Austrian schilling
Finnish marka
Geraman mark
French franc
Italian lire
Dutch guilder
Portuguese escudo
40,339900
166,386000
0,787564
40,339900
13,760300
5,945730
1,955830
6,559570
1936,270000
2,203710
200,482000
How to organize relations between the
'ins' and the 'outs': main principles
• Main principles decided in ECOFIN meeting in
June 1996:
– A new exchange rate mechanism (the so-called
ERM-II) has replaced the old Exchange Rate
Mechanism (ERM) since 1 January 1999
– Adherence to the mechanism is voluntary
– Its operating procedures are determined in
agreement between the ECB and the central banks
of the 'outs'
– ERM-II is based on central rates around which
relatively wide margins of fluctuations are set.
Countries may choose different margins
• The anchor of the system is the Euro
• When the exchange rates reach the limit of
the fluctuation margin, intervention is
obligatory
• This obligation will be dropped if the
interventions conflict with the objectives of
price stability in the Eurozone or in the
outside country
• The ECB has the power to initiate a
procedure aimed at changing the central
rates
• At this moment Denmark and some Central
European countries have adhered to the
ERM-II
• The UK does not want to be constrained by
an ERM-type of arrangement
• The second EU-country which has not
adhered to the ERM-II is Sweden
Convergence of new
member countries
• When the new member states of the EU
signed the accession Treaty they also
committed themselves to enter the Eurozone
some time in the future
• The exact moment at which this will happen
depends on the fulfillment of the Maastricht
convergence criteria
• These are the same criteria that the present
Eurozone member countries had to satisfy
(equal treatment)
• On 1 January 1 2007 Slovenia was the first of
the new member countries to join
Balassa-Samuelson again
• Potential for conflict between the inflation
criterion and the requirement for joining the
ERM-II
• Central European countries experience high
productivity growth in the tradable sector. This
is part of their catch-up process with Western
Europe
• Thus, structurally higher inflation (measured
by the consumption price index)
• There is really nothing to worry about in this.
When these countries are in the Eurozone
they will show a higher inflation rate that is
part of their catching up process and that
should be considered to be an equilibrating
process
• During the transition process this could be a
problem
– Rate of inflation must be close to the Eurozone
inflation until entry into the monetary union
– Entry into the ERM II also reduces scope to use
the exchange rate as an instrument to lower the
inflationary dynamics coming from high
productivity growth
Balassa-Samuelson model
pcE =  pE + (1 - )wE
pcN =  pN + (1 - )wN
(1)
(2)
During the transition process the exchange rate of the
new member state can change relative to the Euro; we
introduce the purchasing power parity as follows:
e = pE – pN
(3)
– Where pE and pN are the rates of price increases in
the tradable sectors of the Eurozone and the new
member state respectively and e is the rate of
depreciation of the Euro relative to the currency of
the new member state
We now subtract (2) from (1) and use (3). This yields
pcE – pcN = e + (1 - )(wE – wN)
or assuming as before that the wage increases arise
form productivity growth
pcE – pcN = e + (1 - )(qE – qN)
which can be rewritten as
(pcE – pcN ) - e = (1 - )(qE – qN)
The convergence criteria impose constraints
The inflation criterion forces the inflation differential
(pcE – pcN) to be less than 1.5 (in absolute value).
If the exchange rate is not allowed to change (e = 0)
then the inflation criterion cannot be realized if the
productivity growth differential (qE – qN) is higher (in
absolute value) than 1.5 /(1 - ). Assuming that the
share of non-tradables is 0.7, we obtain the
conditions that this productivity differential should not
be larger than 2.1.
• There is some evidence that yearly
productivity growth differentials between the
new member countries and the Eurozone
have been higher than 2.1.
• The problem described here is a little over
dramatized because the requirement to join
the ERM-II does not prevent the exchange
rate from moving somewhat within a given
band of fluctuation
• If the wide band (2 x 15%) is chosen there is
no problem
• Problem arises if the smaller band (2 x 2.25%)
is selected
• Final remark: countries cannot devalue prior
to entry; they can revalue though
• Thus even if the narrow band is selected
counties would still have the option to revalue
their currency
• However, this option would be difficult to
implement systematically because the
knowledge that the authorities could do this
could lead to speculative pressure and
volatility in the market
Is the UK ready
to enter the Eurozone?
• UK satisfies most convergence criteria
• Two economic sources of UK hesitation to join:
a) There is evidence that UK may not form an optimal
currency union with the rest of the EU
b) The pound may be overvalued relative to the Euro
Thus, if the UK enters the Eurozone at too high an
exchange rate it might be saddled with low
competitiveness for years to come, putting
downward pressure on economic growth in the UK
2006-nov
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
Euros per pound
Figure 7.2: Euro–pound exchange rate
(1990–2006)
1,8
1,7
1,6
1,5
1,4
1,3
1,2
1,1
1,0
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
Sterling real effective exchange rate
Figure 7.3: Real effective exchange rate
pound sterling, 1991 = 100
120
115
110
105
100
95
90
85
80
Conclusion
• The transition towards EMU was based on
two principles:
– Gradualism
– Macro-economic convergence
• These principles will continue to be important
for the central European countries, the UK,
Denmark and Sweden when these countries
decide to join the Eurozone
• The technical problems associated with the
start of EMU were solved remarkably well