Monetary Integration in Europe

1. Monetary Integration in Europe Jan Fidrmuc Brunel University

2. Monetary Union • Monetary union implies a choice between exchange rate stability and monetary policy autonomy • The impossible trinity: only 2 of the following possible simultaneously: • Full capital mobility • Autonomous monetary policy • Fixed exchange rates

3. Exchange-rate Regime Alternatives • Free floating exchange rate • Managed float, target zone, crawling peg • Fixed exchange rate, currency board, dollarization

4. Exchange-rate Regime Choice • Adjustment to adverse shocks (business cycles) using monetary policy • Can be misused  inflation • Exchange-rate volatility and vulnerability to speculative attacks • Political pressure on exchange-rate policy

5. Two Corners • Only pure floats or hard pegs are robust: • intermediate arrangements (soft pegs) invite government manipulations, over or under valuations and speculative attacks • pure floats remove the exchange rate from the policy domain • hard pegs are robust to speculative attacks • Soft pegs are half-hearted monetary policy commitments, so they ultimately fail

7. Metallic Money • Before paper money, Europe was a de facto monetary union. • Under metallic money (gold and/or silver) the whole world was really an informal monetary union. • Formal unions only agreed on the metallic content of coins to simplify everyday trading. • Countries cannot issue currency and cannot use the exchange rate to adjust relative prices (e.g. to reverse a current-account deficit or to stimulate demand) • Adjustment occurs through prices and wages

8. The Interwar Period: The Worst of All Worlds • Paper money started circulating widely. • The authorities attempted to resume the gold standard but: • no agreement on how to set exchange rates between paper monies • an unstable starting point due to war legacy • high inflation • high public debts.

9. European Postwar Arrangements • An overriding desire for exchange rate stability: • initially provided by the Bretton Woods system • the US dollar as an anchor and the IMF as conductor. • Once Bretton Woods collapsed, the Europeans were left on their own: • the timid Snake arrangement • the European Monetary System (EMS) • the monetary union.

10. The Bretton Woods System Collapse • Initial divergence (dollar exchange rates).

11. The Snake Arrangement • Agreement on stabilizing intra-European bilateral parities. • No enforcement mechanism: too fragile to survive.

12. The EMS: Super Snake • EMS = European Monetary System • A EU arrangement: all EU members are part of it • ERM = Exchange Rate Mechanism • An agreement to fix the exchange rate • ERM jointly managed • Changes in exchange rates agreed by all members • Fluctuations between +/-2.25% and +/-15% • Mutual support to prop up exchange rates when needed • Allows prompt realignments • Deutschemark gradually emerged as the anchor

13. EMS: Past and Present • EMS originally conceived as solution to the end of the Bretton Woods System • Gradually it became DM centered • The speculative crisis of 1993 made the monetary union option attractive • Now ERM is the ante room for EMU entrants • The UK and Denmark opted out from ERM membership • All the others are expected to enter the ERM sooner or later (cf. Sweden)

14. Preview: The Four Incarnations of the ERM • 1979-82: ERM-1 with narrow bands of fluctuation (±2.25%) and symmetric. • 1982-93: ERM-1 centered on the DM, shunning realignments. • 1993-99: ERM-1 with wide bands (±15%). • From 1999: ERM-2, asymmetric, precondition to full euro-area membership.

15. Four Incarnations of the EMS

16. The ERM: Key Features • A parity grid: • bilateral central parities • associated margins of fluctuations. • Mutual unlimited support: • exchange market interventions • short-term loans. • Realignments: • tolerated, not encouraged • require unanimous agreement. • The ECU: • not a currency, just a unit of account • took some life on private markets.

17. The ECU A basket of all EU currencies.

18. Evolution: From Symmetry to DM Zone • First a flexible arrangement: • different inflation rates: long run monetary policy independence • frequent realignments.

19. Evolution: From Symmetry to DM Zone

21. Evolution: From Symmetry to DM Zone • However: realignments: • barely compensated accumulated inflation differences • were easy to guess by markets  speculative attacks • The symmetry was broken de facto. • The Bundesbank became the example to follow.

22. The DM Zone • What shadowing the Bundesbank required: • giving up of much what was left of monetary policy independence • aiming at a low German-style inflation rate • avoiding realignments to gain credibility.

23. Breakdown of the DM zone • Bad design: • full capital mobility established in 1990 as part of the Single Act ERM in contradiction with impossible trinity unless all monetary independence relinquished. • Bad luck: • German unification: a big shock that called for very tight monetary policy • the Danish referendum on the Maastricht Treaty. • A wave of speculative attacks in 1992-3: • the Bundesbank sets limits to unlimited support.

24. Lessons From 1993 • The two-corner view: • even the cohesive ERM did not survive • go to one of the two corners • monetary union • or floating exchange rate • Interventions cannot be unlimited: • need more discipline and less support • Speculative attacks can hit even robust systems and properly valued currencies (i.e. self-fulfilling crises)

25. The Wide-Band ERM • Way out of crisis: • wide band of fluctuation (±15%) • a soft ERM on the way to monetary union

26. ERM-2 • ERM-1 ceased to exist on 1 January 1999 with the launch of the Euro. • ERM-2 was created to • Host currencies of old EU members who cannot or do not want to join euro area: • Denmark and the UK have derogations • Only Denmark has entered the ERM-2 • Sweden has no derogation but has declined to enter the ERM-2 • Host currencies of new EU members before they are admitted into euro area

27. ERM Members

28. Current ERM-2 Members

29. ERM-1 ERM-2 Symmetric, no anchor currency Asymmetric, all parities defined vis a vis euro Margin explicitly set ‘Normal’ (±2.25%) and ‘standard’ (±15%) bands Automatic unlimited interventions ECB explicitly allowed to suspend intervention ERM-2 vs ERM-1

30. Optimum Currency Areas

31. Optimum Currency Areas? • What currency, or exchange-rate arrangement, is optimal? • For individual countries, groups of countries or regions within a country • What economic criteria should be used?

32. E.g.: California in the early 1990s • Is it optimal for California to use the US dollar?

33. The Economic Toolkit • There are benefits and costs involved in adopting a common currency. • The solution has to involve trading off these benefits.

34. In a Nutshell • Benefits: • No transaction costs, no exchange-rate uncertainty • Decreasing with size of currency area • Costs: • Economic and political diversity • Loss of monetary and exchange rate instruments • Increasing with size of currency area

35. OCA Theory • Focus on the costs of common currency • Especially on asymmetric shocks • What are they? • What problems do they cause in currency unions? • How can their effects be mitigated?

36. Example: A demand shock • Real exchange rate, EP/P*, must depreciate to restore competitiveness • Either prices fall or nominal exchange rate depreciates. • If not: overproduction and unemployment

37. Symmetric Shock • Same demand shock in two similar countries that share the same currency and, therefore, exchange rate: No problem. The same real XR adjustment as before.

38. Asymmetric Shock • Only one country is affected; countries share common currency: Problem! • Country A’s real exchange rate must depreciate both vis-à-vis ROW and Country B

39. Asymmetric Shock • Country A wants a depreciation. • Country B is unhappy: depreciation would lead to excess demand and inflationary pressure.

40. Asymmetric Shock • Country B wants no change. • Country A is unhappy because of excess supply and unemployment.

41. Asymmetric Shock • Common central bank considers preferences of both countries and allows partial depreciation • Nobody is happy.

42. Asymmetric Shock • In the long, the problem is solved. • How?

43. Asymmetric Shock • Prices decline in country A and rise in country B. • Real exchange rate adjusts because of price adjustment. • Equilibrium is restored in both countries through disinflation and recession in A and inflation and expansion in B.

44. Implications of Asymmetric Shocks • Both countries affected adversely when they share the same currency. • Also the case when a symmetric shock creates asymmetric effects (e.g. oil price effects on oil exporting and oil importing countries). • This is an unavoidable cost. • Next questions: • what reduces the incidence of asymmetric shocks? • what makes it easier to cope with shocks when they occur? • Answer: six OCA criteria.

45. Six OCA criteria • Three economic criteria • Labor Mobility (Mundell) • Diversification (Kenen) • Openness (McKinnon) • Three political criteria • Fiscal risk-sharing • Homogeneity of preferences • Solidarity

46. Criterion 1 (Mundell): Labour Mobility • An OCA is an area within which labour moves easily (including across national borders).

47. Criterion 1 (Mundell): Labour Mobility • Labour moves from A to B • The two supply curves shift • Equilibrium is restored without disinflation/inflation.

48. Criterion 1 (Mundell): Labour Mobility • In an OCA labour (and capital) moves easily, within and across national borders. • Caveats: • labour mobility is easy within national borders but difficult across borders (culture, language, legislation, welfare benefits, etc.) • capital mobility: difference between financial and physical capital; physical capital is less mobile than financial capital • with specialization of labor, skills may also matter; migrants may need retraining.

49. Criterion 2 (Kenen): Production Diversification • OCA: countries whose production and exports are widely diversified and of similar structure. • If production and exports are diversified and similar, there are few asymmetric shocks and each of them is likely to be of small concern.

50. Criterion 3 (McKinnon): Openness • OCA: Countries which are very open to trade and trade heavily with each other. • Traded vs non-traded goods: • traded good: prices are set worldwide • a small economy is price-taker, so the exchange rate does not affect competitiveness. • If all goods are traded, domestic goods prices must be flexible and exchange rate does not matter for competitiveness.