Econ 141 Fall 2013

1. Econ 141 Fall 2013 Slide Set 11 The Euro

2. The Eurozone • The euro was adopted by 11 countries on Jan. 1, 1999. These included the major countries of the European Union except Britain. Greece joined in 2001. • It has now been adopted by 17 countries. • 3 countries with national currencies are members of the ERM (Denmark, Latvia and Lithuania) • 7 members of the EU have currencies that float against the euro (U.K., Sweden, Poland, Czech Rep., Hungary, Romania and Bulgaria)

3. The European project • In 1946, Churchill pronounced, “We must build a kind of United States of Europe.” • The advent was the administration of the Marshall Plan creating the European High Authority and subsequent multilateral agencies to manage the rebuilding of post-war Europe. • The next step was the creation of the European Economic Community between France, W. Germany, Italy and Benelux in 1957 (Treaty of Rome).

4. The European project • The first enlargement of the EC was in 1973 (adding Britain, Ireland, Denmark) • The second was the addition of Greece, Portugal and Spain in the 1980’s. • There are now 28 members. • In 1993, the Maastricht Treaty created the European Union with a single market, and set the terms of the European Monetary Union. • The Schengen Treaty was adopted in 1995. • The Treaty of Amsterdam set out EU citizenship, powers of the EU parliament and common foreign and security policy.

5. The creation of the EMU The Maastricht Treaty set five requirements of prospective members prior to membership in the currency union: • Two years with the exchange rate in a single band of the ERM • Inflation within 1.5% of average level of the three countries with the lowest inflation rates • Long-term nominal interest rates within 2% of the same three • Government deficit of no more than 3% of GDP in the previous fiscal year • Government debt no more than 60% of GDP in the previous year

6. The theory of optimum currency areas • An optimum currency area (OCA) is a group of countries for which the benefits of adopting a single currency outweigh the costs. Market integration and efficiency gains: the greater the degree of integration, the greater the gains from eliminating exchange rate changes. Economic symmetry and stabilization: the more similar (more symmetric and smaller are shocks), the lower the costs of eliminating monetary autonomy.

7. The theory of optimum currency areas • The net benefits of adopting a common currency equal the benefits minus the costs. The two main lessons we have just encountered suggest the following: • As market integration rises, the efficiency benefits of a common currency increase. • As symmetry rises, the stability costs of a common currency decrease.

8. Fixed exchange rates versus a currency union • When countries consider forming a currency union, the economic tests (based on symmetry and integration) set a higher bar than they set for judging whether it is optimal to fix. • For example, Denmark is in the ERM, so the krone is pegged to the euro, but not in the Eurozone. Denmark appears to have ceded monetary autonomy to the ECB, but transactions between Denmark and the Eurozone still require a change of currency. • By keeping its own currency, Denmark has the option to exercise monetary autonomy or leave the ERM at some future date if they want the flexibility of a more freely floating exchange rate.

9. Italy is one of several countries in which rumors of departure from the Eurozone have surfaced from time to time. • An Italian exit from the euro would be difficult and costly. Reintroducing new lira as money would be difficult and, more seriously, all Italian contracts in Euros would be affected by the “lirification” of the euro. • Other countries that have tried these kinds of strategies, such as “pesification” in Argentina and de-dollarization in Liberia, have resulted in economic crises. • Exiting a common currency is much more difficult than quitting a peg.

10. Optimum Currency Area Criteria Labor Market Integration: In the event of an asymmetric shock, labor market integration provides an alternative adjustment mechanism. With an excess supply of labor in one region, adjustment can occur through migration. Fiscal Transfers: If fiscal policy is not independent but built on top of a federal political structure with fiscal mechanisms that permit transfers between states (known as fiscal federalism),then a third adjustment channel is available. If Home suffers a negative shock, fiscal transfers from Foreign allow more expansionary fiscal policy in Home.

11. Optimum Currency Area Criteria • Fiscal cooperation and labor mobility shift the OCA line down.

12. Optimum Currency Area Criteria Monetary Policy and Nominal Anchoring: Countries that suffer from chronic high inflation can gain by transferring monetary policy to a more politically independent common central bank in a currency union. The central bank could resist local political pressure to use expansionary monetary policy for short-term gains. • Italy, Greece, and Portugal are Eurozone members that historically have been subject to high inflation. • High-inflation countries are more likely to want to join the currency union the larger are the monetary policy gains of this sort.

13. Optimum Currency Area Criteria Political Objectives: It is possible that countries will join a currency union even if it makes no pure economic sense for them to do so. • Forming a currency union has value for political, security, strategic, or other reasons. • Political benefits can be represented by a shift down in the OCA line. In this case, the economic costs to forming a currency union outweigh the benefits, but this costs is outweighed by political benefits.

14. Optimum Currency Areas: Europe versus the United States Goods Market Integration within the EU As intra-EU trade flows rise further, the EU’s internal market should become more integrated, but Europe is probably less integrated than the U.S. Symmetry of Shocks within the EU Most EU countries compare favorably with the U.S. states in these terms. There is no strong consensus that EU countries are more exposed to local shocks than the regions of the U.S.

15. Trade Integration

16. Macroeconomic Symmetry

17. Optimum Currency Areas: Europe versus the United States Labor Mobility within the EU: Labor in Europe is much less mobile between states than it is in the U.S. The flow of people between regions is also greater in the U.S. than in the EU. • Labor markets in Europe are generally less flexible, and differences in unemployment across EU regions tend to be larger and more persistent than they are across the individual states of the U.S. Fiscal Transfers: Stabilizing transfers, whereby substantial taxing and spending authority are given to the central authority, exist in the U.S. but not in the EU.

18. Labor Mobility

19. Are the OCA Criteria Self-Fulfilling? • Some economists conjecture that by adopting a common currency, Europe might become an OCA in the future. • Joining a currency union might promote more trade by lowering transaction costs. • If the OCA criteria were applied ex ante (before the currency union forms), then many countries might exhibit low trade volumes. • It might be the case that ex post (after the currency union is up and running) countries would trade so much more that in the end the OCA criteria would indeed be satisfied.

20. Operating the euro, 1999-2007 The ECB • Instrument and goals. The instrument used by the ECB is the interest rate at which banks can borrow funds. According to its charter, the ECB’s primary objective is to “maintain price stability” in the euro area and its secondary goal is to “support the general economic policies in the Community.” • Forbidden activities. The ECB may not directly finance member states’ fiscal deficits or provide bailouts to member governments. The ECB has no mandate to act as a lender of last resort by extending credit to financial institutions in the Eurozone in the event of a banking crisis.

21. The ECB • Governance and decision making. Monetary policy decisions are made at meetings of the ECB’s Governing Council, which consists of the central bank governors of the Eurozone national central banks and six members of the ECB’s executive board. • Accountability and independence. No monetary policy powers are given to any other EU institution. No EU institution has any formal oversight of the ECB, and the ECB does not have to report to any political body. The ECB does not release the minutes of its meetings. The ECB has more independence than most central banks.

22. Criticisms of the ECB • There is controversy over the price stability goal. The price inflation target rate of less than but “close to” 2% per year over the medium term is vague (the notions of “close to” and “medium term” are not defined). • The target is also asymmetrical (there is no lower bound to guard against deflation), which was a concern during the Great Recession following the global financial crisis of 2008. • The ECB has acted as if it places little weight on economic performance, growth, and unemployment, and where the real economy is in the business cycle.

23. Criticisms of the ECB • There is controversy over the ECB’s use of a reference value for money supply growth (4.5% per annum). A fixed money growth rate can be consistent with an inflation target only by chance. • There is controversy over the strict interpretation of the “forbidden activities” rules. What happens in the event of a large banking crisis in the Eurozone? • There is controversy over the decision-making process. Consensus decisions may favor the status quo, causing policy to lag when it ought to move.

24. A very large Council makes consensus more difficult to achieve, especially as more countries join the euro, but the structure of the Council is set in the Maastricht Treaty and would be impossible to change without revising the treaty. • There is controversy over the ECB’s lack of accountability. Many EU bodies suffer a perceived “democratic deficit,” with treaties pursued at the intragovernmental level and no popular ratification or consultation.

25. Central bank independence • For historical reasons, Germany has strong anti-inflation preferences. These shaped the conduct of monetary policy from 1958 to 1999. To ensure that the Bundesbank could deliver a firm nominal anchor, it was carefully insulated from political interference. • Sometimes, the inflation target is set by the government, in the so-called New Zealand model. • But the so-called German model went further: the Bundesbank was granted full independence, and given both instrument independence (freedom to use interest rate policy in the short run) and goal independence (the power to decide what the inflation target should be in the long run). • This became the model for the ECB, when Germany set most of the conditions for entering a monetary union with other countries where the traditions of central bank independence were weaker or nonexistent.

26. Inflation bias and monetary policy • A deep problem in modern macroeconomics concerns the time inconsistency of policies. • All countries face a problem with inflation bias under discretionary monetary policy. Without a credible commitment to low inflation, a politically controlled central bank has the temptation to use “surprise” monetary policy expansions to boost output. Eventually, this bias will be anticipated and built into inflation expectations. • In the long run, real outcomes—such as output and unemployment—will be the same whatever the extent of the inflation bias. Long-run money neutrality means that printing money can’t make an economy more productive or create jobs.

27. A historically low-inflation country (e.g., Germany) might be worried that a monetary union with a high-inflation country (e.g., Italy) would lead to a monetary union with on average a tendency for inflation in the middle due to looser monetary policies for Germany and tighter ones for Italy. • In the long run, Germany and Italy would still get the same real outcomes (though in the short run, Germany might have a monetary-led boom and Italy a recession). Italy might gain in the long run from lower inflation, while Germany would lose from the shift to a high-inflation environment. Germany wanted assurances that this would not happen.

28. The rules of membership Nominal Convergence • Under a peg, the exchange rate must be fixed or not vary beyond tight limits. • Purchasing power parity (PPP) then implies that the two countries’ inflation rates must be very close. • Uncovered interest parity (UIP) then implies that the two countries’ long-term nominal interest rates must be very close.

29. 10- year Government Bond Yields, major members of Eurozone

30. The rules of membership Fiscal Discipline The Maastricht Treaty saw the fundamental and deep causes of inflation as being not monetary, but fiscal. • The other two Maastricht rules are openly aimed at constraining fiscal policy. • These levels were chosen somewhat arbitrarily: a deficit level of 3% of GDP and a debt level of 60% of GDP.

31. How did this work out?

32. The Stability and Growth Pact • Within a few years of the Maastricht Treaty, the EU suspected that greater powers of monitoring and enforcement would be needed. • Thus, in 1997 at Amsterdam, the EU adopted the Stability and Growth Pact (SGP), which the EU website has described as “the concrete EU answer to concerns on the continuation of budgetary discipline in Economic and Monetary Union.”

33. The Stability and Growth Pact Shortcomings of the SGP: • Surveillance failed because member states concealed the truth about their fiscal problems. • Punishment was weak, so even when “excessive deficits” were detected, not much was done about it. • Deficit limits rule out the use of active stabilization policy, and shut down the “automatic stabilizer” functions of fiscal policy. • Once countries joined the euro, the main “carrot” enticing them to follow the SGP’s budget rules (or to pretend to follow them) disappeared. Hence, surveillance, punishment, and commitment all weakened once the euro was in use.

34. The Eurozone in crisis, 2008-2010 • Debtors in the private sector were engaged in a credit-fueled boom, while creditors and their banks funneled ever more loans toward the borrowers. • The creditors were Northern European countries like Germany and the Netherlands; the debtors were fast-growing nations such as Greece, Italy, Portugal, and Spain. • Once the global boom turned to bust, the overconsumption was revealed to have been unjustified and unsustainable.

35. House prices fell, as did the value of firms. Wealth collapsed, lowering aggregate demand more. Output fell in the short run, as did tax revenues. Households cut spending further, and the governments also tightened their belts. Banks tightened lending and the spiral continued. • Governments tried to guarantee their private banks and prevent bank runs but this simply socialized private losses, and transferred the financial sector’s massive hole onto the government’s books. • Governments kept borrowing from the private banks, the banks kept earning profits, and the ECB continued to lend to the private banks against the ever-weaker collateral of the peripheral governments’ bonds.

36. By 2009 and 2010 the bonds issued by some of the peripheral governments were being given near-junk credit ratings. • In early 2010, fears in financial markets quickly spread from the peripheral countries to the rest of the Eurozone. Government risk premiums on peripheral debt grew to alarming levels amid fears of an imminent default in Greece and perhaps other members. • As the value of the euro fell in May 2010, EU leaders began a series of financing operations effectively bailing out member governments and propping up the banks. The ECB was critical to these policies.

37. 10- year Government Bond Yields, major members of Eurozone

38. The EU and International Monetary Fund (IMF) jointly devised a plan to renegotiate Greek government debt and provide emergency loans to Greece. • Financial market panic continued. To help other troubled members, the EU established the European Financial Stability Facility (EFSF) to provide loans of up to €440 billion, founded on the good credit of the other EU members and a once unimaginable bond-buying commitment from the ECB. • To service their large euro-denominated debt, peripheral countries like Greece, Ireland, Portugal, and Spain need to see their economies recover and their nominal GDP grow (as measured in euros).

39. Target 2 imbalances • A pressing problem for the Eurozone is the accumulation of Target 2 balances with the ECB. In essence, these are reserve assets, in euros, accumulated by one member country against another. • As one country runs a bilateral current account surplus against another, it accumulates these reserve claims at the ECB while the other country accumulates a reserve deficit. • The current account imbalances have been sizable as the next figure shows. • The Target balances accumulate the current imbalances and are very lopsided. A major concern is that these balances are not limited other than netting out to zero.

42. Implications for the future of the euro • Target 2 imbalances have become a substantial concern for the net creditor countries. It is claimed that these balances may be unsustainable and eventually could become fiscal transfers. • If they can never be requited in real value, then the creditor countries will realize losses. If they are expected to be inflated away, then a moral hazard problem arises in national policy making. • Another concern is that if the Eurozone breaks up, the imbalances will be written off at a large loss to the creditor countries.