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Chapter 17 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Chapter 17 The European Monetary Union 2 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Long Road to Maastricht and to the Euro 3 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Maastricht Treaty • A firm commitment to launch the single currency by January 1999 at the latest. • A list of five criteria for admission to the monetary union. • A precise specification of central banking institutions. • Additional conditions mentioned (e.g. the excessive deficit procedure). 4 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Maastricht Convergence Criteria • Inflation: – not to exceed by more than 1.5 per cent the average of the three lowest inflation rates among EU countries. • Long-term interest rate: – not to exceed by more than 2 per cent the average interest rate in the three lowest inflation countries. • ERM membership: – at least two years in ERM without being forced to devalue. • Budget deficit: – deficit less than 3 per cent of GDP. • Public debt: – debt less than 60 per cent of GDP: • Note: Observed on 1997 performance for decision in 1998. 5 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Convergence Criteria: Inflation convergence 10.00 5.00 0.00 1991 France Spain Belgium Greece 1992 1993 1994 1995 1996 1997 1998 Italy Germany Portugal average of three lowest + 1.5% 6 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Convergence Criteria: Interest rates and ERM • Long-Term Interest Rate: easy to bring inflation down in 1997 and then let go again. • ERM Membership: need to convince the exchange markets. 7 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Convergence Criteria: Budget Deficit and Debt • Historically, all big inflation episodes born out of runaway public deficits and debts. • Hence requirement that house is put in order before admission. • Problem No. 1: – a few years of budgetary discipline do not guarantee long-term discipline • Problem No. 2: articifial ceilings. 8 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Debt and Deficit in 1998 9 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Architecture of the monetary union 10 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition A Tour of the Acronyms • N countries with N National Central Banks (NCBs) that continue operating but with no monetary policy function. • A new central bank at the centre: the European Central Bank (ECB). • The European System of Central Banks (ESCB): the ECB and all EU NCBs (N=27). • The Eurosystem: the ECB and the NCBs of euro area member countries (N=16). 11 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The System 12 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition How Does the Eurosystem Operate? • Objectives: – What is it trying to achieve? • Instruments: – What are the means available? • Strategy: – How is the system formulating its actions? 13 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Objectives • The Maastricht Treaty’s Art. 105.1: ‘The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community […].’ • Article 2. The objectives of European Union are a high level of employment and sustainable and non-inflationary growth. 14 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Objectives (cont.) • Does the Eurosystem have a target? “In the pursuit of price stability, the ECB aims at maintaining inflation rates below, but close to, 2% over the medium term. ” • Leaves room for interpretation: – where below 2 per cent? – what is the medium term? 15 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Instruments • Remember the channels of monetary policy: – – – – longer run interest rates credit asset prices exchange rate. • These are all beyond central bank control. • Instead it can control the very short-term interest rate: European Over Night Index Average (EONIA). 16 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Instruments (cont.) • The Eurosystem controls EONIA by establishing a ceiling, a floor and steering the market in-between. • The floor: the rate at which the Eurosystem accepts deposits (the deposit facility). • The ceiling: the rate at which the Eurosystem stands ready to lend to banks (the marginal lending facility). • In-between: weekly auctions (main refinancing facility). 17 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition EONIA & Co. 7 6 5 4 3 2 1 0 Jan-99 Jan-00 EONIA Jan-01 Jan-02 Deposit rate Jan-03 Jan-04 Marginal lending Jan-05 Jan-06 Main refinancing Source: ECB 18 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Two-Pillar Strategy • The monthly Eurosystem’s interest rate decisions (every month) rests on two pillars. • Economic analysis: – broad review of economic conditions: • growth, employment, exchange rates, abroad. • Monetary analysis: – evolution of monetary aggregates (M3, etc.). 19 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Comparison With Other Strategies • The US Fed: – legally required to achieve both price stability and a high level of employment – does not articulate an explicit strategy. • Inflation-targeting central banks (Czech Republic, Poland, Sweden, UK, Hungary): – announce a target (e.g. 2% HICP in the UK), a margin (e.g. ±1%) and a horizon (2–3 years) – compare inflation forecast and target, and act accordingly. 20 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Independence and Accountability • Arguments for central bank independence: – governments tend not to resist to the ‘printing press’ temptation – the Bundesbank has set an example. • But misbehaving governments are eventually punished by voters. • Independence removes central banks from such pressure. • A democratic deficit? 21 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Redressing the Democratic Deficit • In return for their independence, central banks must be held accountable: – to the public – to elected representatives. • Example: • the Bank of England is given an inflation target by the Chancellor. It is free to decide how to meet the target, but must explain its failures (the ‘letter’) 22 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Independence and Transparency 23 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Eurosystem’s Weak Accountability • The Eurosystem must report to the EU Parliament. • The Eurosystem’s President must appear before the EU Parliament when requested, and does so every quarter. • The EU Parliament cannot change the Eurosystem’s independence and has limited public visibility. 24 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Record So Far • A difficult period: – an oil shock in 2000 – September 11 in 2001 – Oil prices to record level and US financial crisis start in mid-2007 • Result: – Inflation almost always above 2% but close to target and lower than perceived 25 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Inflation record: eurozone Euro Area Inflation 3.5 3 2.5 2 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 1.5 1 0.5 0 Source: Eurostat 26 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Growth record: eurozone 27 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Exchange rate: from too weak to too strong? ECB reference exchange rate, US dollar/Euro 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: ECB 28 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Asymmetries: some evidence of decrease 29 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Lasting inflation differentials • Issue of lasting inflation differentials – Lower than average in: Germany, France and Finland – Higher than average: Ireland, Spain, Portugal, Netherlands and Italy • Possible causes: – – – – – Catching up in productivity levels Wrong starting conversion rates Autonomous wage and price setting Policy mistakes, such as fiscal expansion Asymmetric shocks, such as oil price effects 30 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition New EU members and EMU • Obligation to meet the 5 convergence criteria • Yearly publication of ‘Convergence Reports’ to assess how they meet the convergence criteria • Whilst Slovenia, Malta, Cyprus and Slovakia are members, Lithuania was rejected and the rest are still to meet criteria 31 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition