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Convergence Criteria and European financial crisis. ECONOMIC AND MONETARY UNION (EMU). Optimal Currency Area. The Optimal C urrency Area theory was behind the European Single Currency argument. It requires: An absence of asymmetric shocks

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convergence criteria and european financial crisis

ConvergenceCriteriaand Europeanfinancialcrisis

ECONOMIC AND MONETARY UNION (EMU)

optimal currency area
Optimal Currency Area

The Optimal Currency Area theory was behind the European Single Currency argument. It requires:

  • An absence of asymmetric shocks
  • A high degree of labour mobility and wage flexibility
  • Centralised fiscal policy

Thus, to meet conditions above, there is a convergence criteria for establishing Eurozone.

economic benefits of emu
Economic benefits of EMU
  • Removes exchange rate uncertainty on intra-EMU trade
  • Avoids competitive devaluations
  • Eliminates transaction costs
  • Increases price transparency
  • Low and stable inflation and interest rates
  • Promotes international specialisation and improves EU competitiveness
  • Boosts the EU’s international economic profile
economic risks of emu
Economic risks of EMU
  • Short term deflation
  • ‘Can one monetary policy fit all’?
  • Loss of economic sovereignty and self determination in monetary policy
  • Asymmetric shocks? – especially if EMU lead to specialisation.
  • Lack of real economic convergence
  • Burden of adjustment on wages and prices – internal devaluation needed
the path to euro
The path to Euro
  • Werner Report – proposes EMU by 1980
  • 1979 European Monetary System - ERM, ECU
  • 1989 Delors Report – 3 stage approach to EMU
  • 1993 Maastricht Treaty – EMU framework and timetable
  • 1992-3 ERM (Exchange Rate Mechanism) crises
  • 1.1.99 - fixing of exchange rates
  • 1.1.02 – notes and coins in circulation
convergence criteria maastricht criteria
Convergence Criteria(Maastricht criteria)
  • For European Union member states to enter the third stage of European Economic and Monetary Union (EMU) and adopt the euro as their currency
  • The 4 main criteria are based on Article 121(1) of the European Community Treaty.
convergence criteria
Convergence Criteria
  • The purpose of setting the criteria is to maintain the price stability within the Eurozone.
convergence criteria1
Convergence Criteria
  • Monetary criteria
    • Inflation no more than 1.5 percentage points above the average of the 3 countries with the lowest rates
    • Long term interest rates no more than 2 percentage points above the average of the 3 countries with the lowest rates Exchange rate

– has joined ERM II (Exchange Rate Mechanism) for previous 2 years and not devalued its currency

convergence criteria2
Convergence Criteria
  • Fiscal criteria
    • National budget deficit less than 3% GDP
    • National debt less than 60% of GDP – or heading in the right direction
convergence criteria3
Convergence Criteria
  • 12 member states form the Euro-zone – all pre-2004 member states
  • UK and Denmark ‘opt-out’
    • Danish referendum: February 2000 – 53% against
    • Sweden remains out: September 2003 ‘no’ vote
european central bank ecb
European Central Bank (ECB)
  • Independent and supranational
  • Primary objective is price stability
  • Responsibility for monetary policy – i.e. interest and exchange rate policy.
  • Fiscal policy – remains national – but Growth and Stability Pact to stop member states undermining ECB
slide12

€/S rate: Jan 1999 - May 2012

Source: European Central Bank

march 2005 stability and growth pact reforms
March 2005 – Stability and Growth Pact reforms
  • 3% budget deficit/60% debt thresholds remain
  • ‘relevant factors’ to enable member states to avoid ‘excessive deficit’ procedures
    • e.g. economic cycle, structural reform, research and development, public investment, etc
  • Countries have longer time to correct ‘excessive deficit’ – 2 years. Can be extended further.
uk not on the agenda in short or medium term
UK - not on the agenda in short or medium term
  • Political parties
    • Labour in favour ‘in principle’ but some dissenters
    • Conservatives – mostly Eurosceptic – some pro
    • Liberal Democrats – the most ‘pro’
  • Businesses – divided
    • Foreign investors – more pro
    • Big companies – more pro than anti
    • Small companies – more anti than pro
  • Public opinion
    • Heavily anti – how deeply held?
sweden and denmark
Sweden and Denmark
  • Referenda defeat pushed membership back
  • Some more positive attitudes to membership emerging but:
    • Politicians wary of further defeats
    • Difficult to justify
convergence criteria 2005
Convergence criteria - 2005

Source: national governments and Eurostat:

X = above threshold value

sovereign debt
Sovereign Debt
  • Government (sovereign) debt typically considered to be of the highest quality due to ability to manage fiscal (tax) policy and monetary policy
  • Eurozone members control fiscal policy for their own countries but not monetary policy
  • Different levels of debt are incurred by each of the eurozone countries as seen in Exhibit 5.10
  • Greece with a debt/GDP ratio of 166% is the highest
the european debt crisis of 2009 2012
The European Debt Crisis of 2009-2012
  • October 2009 the newly elected Greek government discovers the previous administration has systematically under-reported the government debt
  • Greek financial instruments are down graded
  • Financial markets fear Greek default and financial contagion to other financially weak eurozone countries
  • March 2010 the IMF helps establish a plan to stabilize the Greek economy
the european financial stability facility efsf
The European Financial Stability Facility (EFSF)
  • EFSF designed to raise €500 billion to extend credit to distressed member states
  • Ireland:
    • Unlike Greece, their problems are similar to those in the U.S., a property bubble and the failure of the banking system
  • Portugal
    • Problems may actually be contagion as their financial problems did not appear to be as serious as Greece or Ireland
transmission
Transmission
  • Greek, Irish, and Portuguese government debt was held by many European banks
  • These banks were considered too big to fail
  • The risky sovereign debt was trading at deep discounts and with high yields
  • Further bailouts of Greece and others were becoming necessary
  • Exhibit 5.11 illustrates what happened to interest rates
  • Who would buy such risky debt? See Exhibit 5.12
moving ahead in europe
Moving Ahead in Europe
  • How much money is needed in the coming years for eurozone countries? Exhibit 5.13
  • Solutions to the debt crisis
    • Greece needed immediate capital to manage debt obligations and run their government
    • European banks needed to be protected from the plunging value of the sovereign debt of Greece, Ireland, Portugal and the like
    • Address the long-term fundamental issues of government deficits with ...in some cases austerity measures
alternative solution to the eurozone debt crisis
Alternative Solution to the Eurozone Debt Crisis
  • The Brussels Agreement - a failed attempt to write down sovereign debt values, increase funds in the EFSF, and increase required bank equity capital – contingent upon Greek acceptance of new austerity measures, but the Greeks hesitated
  • Debt-to-Equity Swaps – these come at a cost as the debt value is trimmed before conversion to equity
  • Stability Bonds – Issued with the full backing of every eurozone country rather than individual sovereign debt – resisted by the stronger countries
currency confusion
Currency Confusion
  • Has the sovereign debt crisis put the euro at risk?
  • YES
    • Too much euro-denominated sovereign debt could raise significantly the cost of financing as could the failure of eurozone countries to meet convergence standards
  • No
    • Bad sovereign debt should affect each country more than the group of euro nations
    • Very little empirical evidence thus far that the crisis has really devalued the currency
sovereign default
Sovereign Default
  • Exhibit 5.14 provides a brief history of sovereign defaults since 1983, and their relative outcomes.
  • U.S. response to the 2008-2009 credit crisis was: write-offs by holders of bad debt, government purchase of debt securities, and government capital injections to support liquidity
  • Europe has chosen a similar path as the last technique.
  • banks are not participating to the same extent as in the U.S.