Transcript Economic and Monetary Union

Europe’s Economic and
Monetary Union
Juyeon Lee
European Central Bank
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Central bank for the EU’s currency (Euro)
The ECB’s main task is “to maintain the euro's purchasing
power and thus price stability in the euro area.”
Mission Statement: “The main objective of the Eurosystem
is to maintain price stability: safeguarding the value of the
euro.”
Also: “Without prejudice to the objective of price
stability, the ESCB (European System of Central Banks)
shall support the general economic policies in the
Community with a view to contributing to the
achievement of the objectives of the Community as laid
down in Article 2." (Treaty article 105.1)
The Euro Zone
European Monetary System (EMS)
Established in March 1979
 Components
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European Currency Unit (ECU): nominal currency made up
of a basket of all EC currencies. Later replaced with Euro.
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The European Monetary Institute (EMI: Formerly the
European Monetary Co-operation Fund):
to facilitate currency transactions between member states.
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The Exchange Rate Mechanisms (ERM): established in 1979
as a mechanism for reducing fluctuations in the relative
values of member currencies.
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The Exchange Rate Mechanism (ERM)
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Based on a Parity Grind System
Before the crisis of ’92 and 93, set margin of
fluctuation against a central rate for each currency:
+/- 2.25% within the normal (narrow) band, +/- 6%
within the wide band.
Fluctuation within the wide band is provisional.
UK: Seeing the benefit of ERM in stabilizing currencies
and keeping inflation low, the UK later joined the
ERM in 1990.
The Crises of ‘92-93 and Weaknesses of the ERM
Ended the 12 years of relative stability
 Sterling and lira forced out of the ERM
 Big devaluation of Spanish, Irish, and Danish currencies
 Causes
1. Germany’s monetary policies during 1992 and ’93 (borrowing
rather than raising taxes or revaluing Deutche Mark, which
forced other governments to keep their interest rate high).
2. Insufficient cooperation between member states and
inflexibility
3. “Eurosceptics” argued the ERM is fundamentally flawed.
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Toward a Single Currency
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Steps for the single currency according to the Maastricht
Treaty
Stage 1(July 1, 1990 to Dec. 31 1993): in 1990, a convergence
framework was established, which included the adoption of an
annual economic report and multilateral surveillance over
member states’ economic policies.
State 2(From Jan. 1, 1994): the EMI was established to
strengthen coordination of member states’ central banks and
monetary policies.
Stage 3: a move toward irrevocably fixed exchange rates and
single monetary policy for member states. Sanctions will be
imposed on a member states running excessive deficits. The
ECB was established to take over the EMI.
The Convergence Criteria
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Disparities between convergence criteria and the actual
economic performance of most member states: raising a
doubt of “Can the Maastricht schedule be carried out?”
The European Commission’s Report in 1995
Good progress made on price stability (8 out of 12 met the
convergence criteria)
More progresses needed in governments’ fiscal deficits
Criticism of the Convergence Criteria: Political rather than
economical (to motivate countries to join the exclusive,
secret club). Poor nations have difficulties meeting the
criteria.
Example: the French government’s austerity plan in 1995.
Against the Currency Union
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Mundell’s Case against the Monetary Union
The loss of a major macroeconomic policy called an
independent interest rate to deal with “asymmetric shocks,”
i.e. varying economic conditions between states.
Mundell concluded that if a state cannot handle asymmetric
shocks only with wage reductions and more flexible labor,
then it should not join a monetary union
Criticisms of Mundell’s Theory
Ignoring the benefits of single currency such as low
transaction costs, more efficient market, greater economic
certainty, lower interest rates, and higher economic growth.
The use of exchange rate to deal with asymmetric shocks has
limits and has long-term consequences.
Ignoring the fact that political considerations often override
economic calculations.
Maastricht Treaty’s Convergence Criteria
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Price Stability: an average inflation rate must not
exceed that of the three best performing member
states by more than 1.5%
Interest rates: must not exceed that of three bestperforming member states by 2%.
Government Budgetary policies: current account deficit
must not exceed 3% of GDP, and a gross public debt
must not exceed 60% of GDP.
Currency Stability: +/- 2.5% for those in the narrow
band of the ERM for at least 2 years and with no
currency devaluation.
The Treaty and Monetary Policy
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An Independent Central Bank
A main goal of price stability:
The role of the European Central Bank in monetary policy
Define and implement monetary policy
Conduct foreign exchange operations
Hold and manage the official reserves of the member states.
Promote the smooth operations of payments systems.
The Council of Economic and Finance Ministers (EcoFin):
can make a final decision in foreign exchange markets
(unanimously) and conclude monetary agreements with third
countries.
Why a single currency?
Krugman’s Theory: benefits of a single currency depend
on the level of “economic integration.” Nations
depending on intra-trades will try to form a single
currency to reduce the transaction costs.
 Barriers for the EU to form a single currency
1. High degree of divergence among the 15 EU states.
2. Low level of labor market flexibility (both in the labor
mobility between states and in the flexibility regarding
wage and regulation)
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Interestingly, second-tier nations are keener to join the
single currency than more wealthy members – political
calculations have been major factors.
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The Independence of the Central Bank
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More power to the Central Bank to discourage a government
from using a “surprise inflation” to spur growth.
Delegation of monetary policy (setting interest rate) to an
independent central bank
The central bank should set inflation and money supply
targets
Goal of price stability should be in constitution, not simply in
law (so no more meddling by legislators)
Terms of office of the central bank officials can be longer
than those of political reps who appoint them.
Sanctions if the central bank fails to meet the goal of price
stability.
The ECB’s Independence and Reputation
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The ECB: solely responsible for implementing monetary
policy without interference from the Council or national
governments.
However, few sanctions if the ECB fails to meet the price
stability goal.
To enhance the reputation: any central bank must have a
history of stable currency and economic growth as a
result of its decisions.
The ECB lacking that history (because of its short tenure):
The public might turn against the ECB more easily than it
would be against the well-established central banks like
Bundesbank and the US Feds.
History of Europe’s Monetary Integration
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“Bad Luck” interpretation: whenever the process was
entering a crucial stage, crises (the collapse of the Bretton
Wood System, currency crisis in ’92 and ’93, Collapse of
the Soviet Union, etc).
Used to justify the case for EMU (Economic and
Monetary Union).
The Political process toward the EMU
Key issue: will the costs be shared symmetrically across
countries?
 Economists (Germany, the Netherlands) vs. Monetarists
(France and Italy)
1. Economists argued that if a nation wanted to join the
monetary union, it must converge on a common set of
real economic structures before locking exchange rates.
2. Monetarists: Locking exchange rates will bring about the
convergence of real economic structures.
3. More subtle issue: will France’s economy converge on
Germany’s or will the two reach the middle ground?
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German-French relation and the EMU
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First phase of negotiation: Germany made minor
concessions (no change in its econ. structures), indicating
that the French economy would converge on the German
one.
Second phase (1979 – 1988): both countries’ interests in
the strong relationship. Germany reaffirmed its own
economic structures and others demonstrated willingness
and ability to converge on German norms.
Third phase (1988 - ): More modeling from the German
economy. Other member states to build a set of
institutions patterned on the German model and
dedicated to the fulfillment of German econ. objectives.
The German Unification and Response
The end of Cold War and German Unification: a “new
Germany” with changed economic structures.
 It would undo the bargains made previously.
 Responding the sudden change in the German economy
1. Locking the previous gains: consolidate the gains in the
Maastricht Treaty. But requiring member states to
adopt austerity policies
2. German economy after the unification: not good
enough to be the reference of a good economy.
3. The goal of Monetary Union: became public issue and
led to the rejection of the treaty by the Danish vote.
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Need for the Monetary Integration
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Despite setbacks, the process toward a single currency
progressed faster than skeptics expected.
Reorganization of national central banks into a coherent
system began.
The EMS’s promise: to “broaden the zone of monetary
stability” to shield European businesses from adverse
effects of volatile exchange rates on trade and investment.
Concern: “Fixed but justifiable” clause on national
exchange rates in the EMS might allow countries to
competitively devalue their currencies.
Monetary integration: response to such a concern.
Building the Support for Monetary
Integration
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Lack of understanding on money, exchange rates, etc.
Nationalist attachment to member states’ own currencies
vs. Euro.
Easy way-out: hope for a strong economic recovery
(maybe good luck): strong economies might help the
public to support more monetary integration
Problem: economic recovery and popular support of the
European integration not strongly positive.
Talking Points:
Can the ECB enhance its reputation as much as most
well-established central banks have done?
2. Will Britain join the Euro Zone sooner than later?
(My guess: yes)
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