European Monetary Integration and Economic Policy Co-ordination: An Overview

1. European Monetary Integration and Economic Policy Co-ordination:An Overview

2. FromBretton WoodstoEuropean Monetary Union

3. Bretton Woods Regime(fixed exchange rates) • Stable exchange rates, but adjustable • US dollar fixed in terms of gold ($35 an ounce) • fixed parity for other currencies in terms of dollar • band around dollar parity: plus or minus 1.0 % • adjustment of parities after consultation with the IMF • adjustments discouraged, allowed in case of serious balance of payments disequilibria, postponed by IMF loans • Central Banks of member countries hold reserves in gold or dollars • and have right to sell dollars for gold to Federal Reserve

4. Bretton Woods Regime(fixed exchange rates) • Consequences • dollar becomes the international currency (international dollar standard or gold exchange standard) • dollar takes on role of reserve currency (interest bearing) • Central Banks must intervene in foreign exchange markets to stabilise the exchange rate of their currencies by buying and selling dollars

5. Problems of B-W regime • Problem 1: Nth Currency Problem • two currencies means one exchange rate • (N currencies mean N-1 independent exchange rates) • both countries cannot independently fix the exchange rate. • EITHER both co-operate (symmetric solution) • OR one follows a policy of “benign neglect” (asymmetric solution). Role played by the USA • Problem 2: Realignments • definition: changing the exchange value of a currency. • rendered difficult by the rules of the regime • postponed as much as possible. • Result:

6. Problems of B-W regime • Problem 3: Speculative attacks • Exchange rate value loses credible • Massive sales (normally) or purchases of the currency. • Breakdown of Bretton-Woods regime • Inflation rises in the United States of America • accelerates because of expansionary fiscal and monetary policies (Vietnam war) • Two effects • Purchasing power value of US$ falls • Other countries “import” American inflation. • Markets start selling dollars in large quantities • Movement started by request of the Banque de France (de Gaulle) to USA to convert its dollar holdings into gold (“exorbitant privilege”).

7. Problems of B-W regime • Breakdown of Bretton-Woods regime (cont’d) • August 15th 1971. Nixon closes “gold window” • December 1971. Smithsonian Agreement: general realignment and increase of band to plus or minus 2.25% March 1973: free floating • Strong fluctuations of European currencies against the dollar – and, therefore, even stronger fluctuations between the European currencies • In this context, the European Monetary System (EMS) is born. • 1976: Jamaica Agreements (official end to Bretton-Woods period)

8. First Steps Towards European Monetary Integration • Establishment of the European Payments Union (EPU) with effect from July 1950. • Principal purpose of EPU: facilitate payments for trade in goods between the OEEC member countries in a world where currency convertibility was still an issue. • The EPU was a clearing union that replaced the existing agreements by a multilateral settlement and credit mechanism: • bilateral claims and liabilities for each country were consolidated on a monthly basis in a single net position which defined the balance of payments situation of the country vis-à-vis the rest of the EPU countries.

9. First Steps Towards European Monetary Integration • Settlements could occur by payment in gold or dollars, or by automatic credit limited by quotas. • EPU set up to allow OEEC countries to liberalise trade in goods during the transition to currency convertibility. • Eichengreen (1993): immediate introduction of currency convertibility would have required large devaluations in addition to the currency realignments of 1949 and a consequent immediate loss in real income. Introduction of EPU avoided this, and gave member countries the time to redeploy their economies before rendering their currencies fully convertible. Without the EPU, multilateral trade in goods would have been endangered.

10. First Steps Towards European Monetary Integration • In December 1958, after many European currencies had become convertible, EPU replaced by European Monetary Agreement (EMA) between OEEC member countries. • The EMA was essentially a “code of behaviour designed for an environment of convertibility” (Ungerer (1997)). Credit for balance of payments financing was no longer automatic but had to be negotiated in each case, and when granted, had a maturity of at most two years. The EMA was ended by the OECD Council in December 1972.

11. First Steps Towards European Monetary Integration • On 1 January 1958, the Treaty creating the European Economic Community (EEC) took effect. • Monetary matters were one of the least concerns in the Treaty. Exchange rate policies came under the jurisdiction of the International Monetary Fund (IMF). • The Treaty did require that the Member States of the newly formed EEC follow economic policies which were compatible with the Brettton-Woods commitments: - currency convertibility, - stable nominal exchange rates, and - liberalisation of capital markets “to the extent necessary to ensure the proper functioning of the common market” (Article 67, EEC);

12. First Steps Towards European Monetary Integration • and with fundamental economic policy objectives (balance of payments equilibrium, high level of employment and a stable level of prices). • The Treaty also required of the Council of Ministers of the Member States that they ensure the coordination of the general economic policies of the Member States (Article 145). • The general rules regarding economic and monetary policies were laid down in Articles 104 to 109 and for the liberalisation of capital movements in Articles 67-73. • A Monetary Committee was created with a purely advisory role.

13. First Steps Towards European Monetary Integration • One event in this period is telling: the German revaluation of 1961, but its lessons were not learnt when the Maastricht revision of the Treaty was undertaken. • Germany was subject to inflationary pressures both on account of a high level of domestic demand and large surpluses in the balance of payments current account. • A restrictive monetary policy on its own would have led, and did lead, to an increase in capital inflows and in inflationary pressures. • It also resulted in an excessive squeeze on domestic demand. • A revaluation of the currency was not encouraged by the IMF nor by certain domestic authorities. • The German central bank, the Bundesbank, did not have the authority to revalue the currency which was a competence of the Federal Government. • In the end, the Bundesbank was obliged to stop its restrictive monetary policies, • and a revaluation of the Deutsche Mark occurred.

14. First Steps Towards European Monetary Integration • The conflict between internal and external balance could have been avoided to a large extent • if both monetary and exchange rate policies had been under the same authority. • But is this politically feasible?.

15. First Steps Towards European Monetary Integration • Meeting of Heads of State or Government of the EEC at the Hague in December 1969 • Requests Council of Ministers to draw up a plan by stages for creation of an economic and monetary union. • task proves difficult because of opposing “economist” and “monetarist” views. • “economists”: first a high degree of convergence in economic fundamentals and policies; • “monetarists”: rapid introduction of a monetary union followed by economic convergence

16. First Steps Towards European Monetary Integration • Creation of Werner Commission in March 1970 to address the issue. • Werner Report (October 1970) • complete liberalisation of capital flows • monetary union = irrevocable fixing of exchange rates • community system of national central banks • centralised economic policy • to be achieved in 3 stages completed by 1980 • compromise between “economist view” and “monetarist view”

17. upper intervention point (+2.25%) (sell $) dollar parity lower intervention point (- 2.25%) (buy $) First Steps Towards European Monetary Integration • Werner project endorsed by European Council in 1971 but... was overtaken by events • The Snake (in the Tunnel) • block floating between March 1973 and Dec. 1978 • tunnel between April 1972 and March 1973 • members change frequently and realign frequently • snake lasts till 13 March 1979

18. Creation of the European Monetary System (EMS) • 13 March 1979: EMS comes into existence • Result of initiative taken by Roy Jenkins in Oct. 1997 and followed up by Helmut Schmidt (German Chancellor) and Valéry Giscard d’Estaing (French President) • Based on a European Council Resolution dated5 December 1978 • Main characteristics and operating procedures contained in an Agreement Between [all] the Central Banks of the Member States of the EEC. • Defined a system of fixed but adjustable exchange rates between participating countries.

19. How EMS addressed Bretton-Woods Regime Problems • Asymmetry • introduction of ECU • a basket of currencies of all Member States • each currency in the basket assigned a weight • the weight could change over time • replaced European Unit of Account

20. The ECUA basket of all EC currencies Belgian franc = Belgian (3.301) and Luxembourg (0.13) franc

21. How EMS addressed Bretton-Woods Regime Problems • Asymmetry (cont’d) • introduction of an Exchange Rate Mechanism • participation in ERM not obligatory • each participating currency assigned a (bilateral) central parity with respect to each of the other participating currencies (defines a parity grid ) • maximum variation of 2.25% on either side of central parity allowed • Italy granted exception of 6% on either side.

22. How EMS addressed Bretton-Woods Regime Problems • Asymmetry (cont’d) • obligatory and unlimited intervention at the margin • suppose 1 DEM equalled 20 BEF (central parity) • market exchange rate could vary between 19.55 and 20.45 BEF • if market rate reached either bound, both the Belgian National Bank and the German Bundesbank had to intervene in the market

23. How EMS addressed Bretton-Woods Regime Problems • Asymmetry (cont’d) • obligatory and unlimited intervention at the margin (cont’d) • if the exchange rate rose to 20.45 (appreciation of mark and depreciation of franc) • the Bundesbank and the Belgian National Bank would have to sell marks and buy francs • German Bundesbank at an advantage because it could print as many marks as it needed • Belgian National Bank at a disadvantage because it had a limited stock of marks to sell. • Why oblige both to intervene?

24. How EMS addressed Bretton-Woods Regime Problems • Asymmetry (cont’d) • obligatory and unlimited intervention at the margin (cont’d) • because as a result of the intervention, the German money supply increased and the Belgian money supply decreased • German interest rates fell and Belgian interest rates rose, stabilising the exchange rate

25. How ERM addressed Bretton-Woods Regime Problems • Realignment • At the request of one or several countries participating in the ERM, a consultation occurred involving the Ministers of Finance and the Governors of the Central Banks of all the participating countries. • These decided whether and to what extent a realignment should take place. • Consequently, realignments were carried out rapidly and with the agreement of the participating countries. • The consultation often limited the extent of the realignment out of fear of loss in competitiveness.

26. How ERM addressed Bretton-Woods Regime Problems • Speculative Attacks • obligatory and unlimited interventions by the two Central Banks whose currencies were involved • markets would then know that between them the Central Banks would not run out a currency • this would reduce the probability of a speculative attack

27. Functioning of ERM of EMS • Four phases in the functioning of the ERM • March 1979 to March 1983 • Participating countries going there own way policy-wise. 7 realignments. • April 1983 to January 1987 • Participating countries beginning to recognise the constraints on policy imposed by the ERM. 4 realignments. • February 1987 to September 1992 • The “hard” EMS. 1 “technical” realignment (Italy). • October 1992 to end 1998 • the period following the “breakdown” of the EMS and preceding monetary union

28. Functioning of ERM of EMS • Four phases in the functioning of the ERM

29. Functioning of ERM of EMS

30. Functioning of ERM of EMS • Why did the ERM “break down” in Sep. 1992? • Remote causes • the system had become too rigid • markets convinced no more realignments before monetary union (Delors effect) • loss of competitiveness of certain countries • large capital flows into high interest rate countries (Italy, Spain and Portugal) • is this compatible with interest rate parity? • risk premium.

31. Functioning of ERM of EMS • Why did the ERM “break down” in Sep. 1992? • Remote causes (cont’d) • the system had become asymmetric and dependent on Germany • the Bundesbank set the interest rate for Germany • the other ERM countries tied their currencies to the German mark • the other ERM countries adapted their interest rate to Germany’s • In the ERM, Germany played the role that the USA played under Bretton-Woods

32. Functioning of ERM of EMS • Why did the ERM “break down” in Sep. 1992? • Proximate causes: • capital flows (liberalisation of capital flows in 1990) • the Bundesbank hikes up its interest rate after re-unification • Maastricht Treaty vote in Denmark and in France • Solution: either floating exchange rates or move to monetary union • Britain chose floating • as did Italy and Spain temporarily • fluctuation margins increased to 15% on both sides of central parity

33. Transition to a Monetary Union • The Delors Report • The Maastricht Treaty • The 3 stages • Stage Two: preparing for monetary union • establishment of the European Monetary Institute • countries shall endeavour to avoid excessive fiscal deficits • the criteria for membership • Stage Three: monetary union

34. Criteria for membership • The government deficit may not exceed 3% of Gross Domestic Product at market prices. • If it does, the Commission must take into account • whether it has declined substantially • and continuously or • the excess is temporary in nature. Furthermore, it must examine whether the deficit exceeds expenditure on investments as well as certain other elements

35. Criteria for membership (cont’d) • Government debt may not exceed 60% of Gross Domestic Product. • If it does, the Commission should take into account • - whether the ratio is diminishing • sufficiently and • - approaching the reference value at a • satisfactory speed.

36. Criteria for membership (cont’d) • The inflation rate is sustainable • and, over the year preceding examination, • does not exceed by more than 1.5% • that of, at most, the 3 best performing • Member States. • The consumer price index shall be used

37. Criteria for membership (cont’d) • Long term interest rates (on long-term government bonds or comparable assets) shall not exceed, • over the year preceding examination, • by more than 2% • that of, at most, the 3 best performing Member States in terms of inflation rates.

38. Criteria for membership (cont’d) 5. The Member State - shall have participated in the ERM of the EMS and - respected the normal fluctuation margins without severe tensions for at least two years before the examination. It shall not have devalued its currency against any other Member State's currency on its own initiative for the same period.

39. Criteria for membership (cont’d) Some authors also add a legal convergence criterion, i.e., the countries legislation should conform to the Treaty in matters such as central bank independence and the ESCB Statute.

40. Transition to Membership • Public finances consolidation • Exchange rate mechanism • Real convergence • not included in Maastricht Treaty criteria • was not a problem for “old” Member States • but may be one for new Member States

41. Cost – Benefit Analysis

42. European Monetary Union

43. 1. One Currency • Creation of a Euro-area • Transition period from 1 January 1999 to 31 December 2001 • because of time needed to print notes, mint coins and adapt banking systems. • Legal Framework • Council Regulation 974/98 of 3 May 1998 • Council Regulation 110397 of 17 June 1997

44. Situation of “Pre-ins” or Outs • Opt-out countries • United Kingdom and Denmark • Countries with a derogation • those that have not satisfied the convergence criteria • Sweden • joined EU too late to obtain an opt-out • still does not satisfy exchange rate and legal convergence criteria (chooses not to do so) • Greece (joined on 1st Jan. 2001) • New Member States are countries with a derogation

45. 2. One Monetary Authority • Single currency  single monetary authority • Federal Reserve System in USA • Federal Reserve Banks, Board of Governors • Bundesbank in Germany • Land Central Banks, Bundesbank • Land Central Banks redefined as Regional Offices (2002) • European System of Central Banks (ESCB) in Euro-area • National Central Banks (NCBs) of all Member States, plus European Central Bank

46. 2. One Monetary Authority • Two models of Central Bank design and behaviour • 1. The “Anglo-French” model. • The Central Bank is subject to the authority of the government (mostly through the Ministry of Finance) • The Central Bank must simultaneously take into account several objectives, mainly price stability, growth and unemployment. • 2. The German model • The Central Bank is politically independent • Its primary objective is price stability • and output and employment goals as long as there is no prejudice to price stability

47. Objectives and Tasks of ESCB • Primary objective • price stability • Subordinate Objective • without prejudice to the primary objective, to support the general economic policies in the Community • with a view to contributing to the achievement of the objectives of the Community

48. Objectives and Tasks of ESCB (cont’d) • Tasks of the ESCB • define and implement the monetary policy of the Community • conduct foreign exchange operations, hold and manage foreign exchange reserves of the Euro-area countries • promote the smooth operation of the payments system (TARGET = Trans-European Automated Real-time Gross settlement Express Transfer system) • contribute to prudential supervision and stability of financial system

49. Organisation of ESCB

50. Organisation (cont’d) • Governing Council • composition • all the members of the Executive Board (6) and the governors of the NCBs of the Member States without a derogation • appointment: minimum five years renewable • main tasks • adopt guidelines and take decisions necessary to ensure performance of tasks entrusted to the Eurosystem; • formulate the monetary policy of the euro area, incl., as appropriate, decisions relating to intermediate monetary objectives, key interest rates and supply of reserves in Eurosystem; • establish the necessary guidelines for their implementation • composition has implications for decision making