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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


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

€/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
  • 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 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.