Download 36 - CERGE-EI

Common Currency
Areas and European
Monetary Union
Copyright © 2010 Cengage Learning
11
Common Currency and the
European Monetary Union
In the 1990s, a number of European nations decided to
give up their national currencies and use a new,
common currency called the euro by joining
European Economic and Monetary Union (EMU)
Today’s lecture aims to answer the following
questions:
• Why did the countries decide to adopt euro?
• What are the costs and advantages of that?
• Is it optimal for Europe to have a single
currency?
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Common Currency Area
• A common currency area is a geographical area
throughout which a single currency circulates
as the medium of exchange.
• Another term for a common currency area is a
currency union.
• Closely related phenomenon is a monetary
union that is a group of countries which have
adopted permanently and irrevocably fixed
exchange rates among the various currencies.
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The Euro
• The Maastricht Treaty of 1992 laid down:
• various criteria for eligibility to join the proposed currency union
• the timetable for the introduction of the new single currency
• and rules concerning the establishment of the European Central
Bank (ECB).
• The euro officially came into existence on 1 January 1999 and
on 1 January 2002 the first euro notes and coins began to
circulate.
• Economic and monetary union (EMU) was seen as necessary to
complete the single European market (SEM).
• The Single European Act, passed by the European Parliament in
1986, identified 300 measures that would have to be addressed
to complete the SEM.
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The Euro
• A series of European Directives was used to tell
member state governments what they needed to
do to achieve the following four goals:
• free movement of goods, services, labour and
capital between member states;
• the approximation of relevant laws and
administrative provisions between member states;
• a common EU-wide competition policy;
• and a system of common external tariffs.
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The Benefits of a Single Currency
• Elimination of Transaction Costs - the cost involved in
converting currencies is a deadweight loss, so reducing these costs
by adopting a single currency provides a clear gain to society.
• Reduction in Price Discrimination - it is less likely that there
will be price discrimination between countries because a single
currency makes it more difficult to disguise price differences.
• Reduction in Foreign Exchange Rate Variability - there will be
no exchange rate fluctuations that create uncertainty for businesses
engaging in trade between EMU countries.
• Businesses could always deal with such uncertainty by engaging in
forward foreign exchange contracts with their banks, but the banks
charged for this service and a single currency eliminates this cost.
• The absence of exchange rate fluctuations make business planning easier
and may boost investment, with benefits for economic growth.
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The Costs of a Single Currency
• The major cost is that a country joining a currency
union gives up both its freedom to set its own
monetary policy, and the possibility of macroeconomic
adjustment through movements in the external value of
its currency.
• Suppose there is a shift in consumer preferences away
from German goods and in favour of French goods.
• The aggregate demand curve will shift to the left in
Germany and to the right in France, leading to
increased unemployment and downward pressure on
prices in Germany, and lower unemployment and
upward pressure on prices in France.
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Figure 1 A Shift in Consumer Preferences Away
from German Goods Towards French Goods
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The Costs of a Single Currency
• If the governments do nothing then the
economies will, in the long run, return to
their natural rates of unemployment.
• If the two countries had retained separate
currencies then the short-run fluctuations
in aggregate demand would have been
alleviated by a movement in the exchange
rate.
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Figure 2 A Shift in Consumer Preferences with
Flexible Exchange Rates
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The Costs of a Single Currency
• Without this adjustment mechanism,
German policy makers may wish to see a
cut in interest rates to boost aggregate
demand
• French policy makers, however, will be
more likely to favor a rise in the interest
rate to contain inflation.
• The ECB would be unable to satisfy both
countries.
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The Costs of a Single Currency
• As discussed in lecture 5, the ECB pursues an
inflation targeting strategy.
• If a country’s inflation rate is below the
Euroland average then monetary policy will be
too tight for that country’s economic
conditions.
• If a country’s inflation rate is above average
then monetary policy will be too loose for that
country’s economic conditions.
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CASE STUDY: The Exchange Rate
Mechanism
• Before the euro, most EU countries were members of the
European Exchange Rate Mechanism (ERM).
• This was a semi-fixed or adjustable peg system that limited
exchange rate fluctuations between member currencies.
• In 1992 international speculators attacked the ERM, selling
the UK pound and French franc heavily against the
German mark.
• The pound was withdrawn from the ERM as a result, and
other adjustments had to be made.
• Because international capital flows can be so huge,
currency pegs like the ERM are always vulnerable to
speculators.
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Optimum Currency Areas
• An optimum currency area is a group of
countries for which it is optimal to adopt a
common currency and form a currency union.
• OCA theory attempts to specify criteria for the
optimality of a currency union for a given group
of countries.
• The qualifier ‘optimal’ is used loosely and
should be taken to refer to the ability of the
countries concerned to limit the costs of
monetary union and enhance the benefits.
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OCAs: Characteristics That Reduce
the Costs of a Single Currency
• A high degree of real wage flexibility so that wages
respond strongly to fluctuations in unemployment will
ensure that long-run equilibrium will be restored
quickly following any macroeconomic disturbance.
• A high degree of labor mobility between the member
countries of a currency union will also ensure
macroeconomic stability.
• In the earlier example, the migration of labour from
Germany to France would alleviate inflationary
pressure in France and keep down unemployment in
Germany.
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OCAs: Characteristics That Reduce
the Costs of a Single Currency
• A high degree of capital mobility can also help
alleviate the problems of asymmetric shocks.
• Residents of a country experiencing recession may
borrow money from residents of a country
experiencing a boom to make up for their temporary
fall in income.
• A high degree of trade integration among a
group of countries will lead to greater benefits
should those countries establish a currency
union.
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CASE STUDY: The Roman Empire
• The first European monetary union was the
Roman Empire. Throughout a geographical
area larger than today’s EU, Roman coins came
to be the predominant medium of exchange.
• The widespread use of Roman money was due
in part to the presence of Roman occupying
forces, but also to the increased amount of
international trade across the empire.
• Rome did not decree its money must be the
single currency.
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CASE STUDY: The Roman Empire
• This common currency area broke down around
the end of 5th century AD.
• The single most important reason for the
breakdown was almost certainly the loss of
financial and political control by the Romans.
• Rising political instability made trade more
risky and difficult so that international trade
integration fell.
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Is Europe an Optimum Currency
Area?
• We can think of the ratio of the sum of intra-EU
exports and imports to GDP as a measure of trade
integration.
• Though variable, the degree of trade integration is quite
high on average.
• It has also been increasing over time.
• The rate of increase appears to have been greater since
the currency union was established, suggesting that the
extent of trade integration may actually be endogenous.
• The figures in Table 1 suggest that there are probably
significant gains from EMU.
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Table 1 Imports Plus Exports of 15 EU Countries
From and To Other EU Countries as a % of GDP
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Is Europe an Optimum Currency
Area?
• Research suggests that continental European labour markets are
among the most rigid in the world, while the UK is now one of
the most flexible.
• One reason is the high degree of collective bargaining that is
common in continental Europe.
• The introduction of the euro may have had a negative effect on
European wage flexibility.
• Many collective wage agreements cover a firm’s workers in a number of
EU countries and a single currency brings transparency to wage
differentials between the firm’s workers in different countries.
• In these circumstances it will be difficult for a firm to avoid raising
wages in Germany, say, when the firm is obliged to raise wages in
France because the labor market is tight, even though there is
unemployment in Germany.
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Is Europe an Optimum Currency
Area?
• The costs to a firm of reducing or increasing its workforce
are generally much higher in continental Europe than is the
case in the USA or the UK.
• On the whole, adjustment to asymmetric shocks through
real wage changes is unlikely to be significant in the euro
area.
• Labour is notoriously immobile across the 12 euro area
countries.
• In fact, even within individual euro area countries labour
mobility is much lower than is the case in the USA.
• Euroland scores very low on this OCA criterion.
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Is Europe an Optimum Currency
Area?
• Prior to the introduction of the euro, financial
integration among Euroland countries was
probably quite low.
• Since the introduction of the euro the
integration of wholesale financial markets has
increased dramatically.
• There is a liquid euro money market with single
interbank interest market rates.
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Is Europe an Optimum Currency
Area?
• In the government bond market the yields on
the bonds of different Euroland governments
are similar and tend to move very closely
together, illustrating the high degree of
integration in this market too.
• Integration of retail financial markets is much
less. There is limited cross-border retail
banking activity and there are persistent
differences in bank lending rates in different
countries.
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Figure 3 Growth Rates in Germany, France and
the Whole Euro Area
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Is Europe an Optimum Currency
Area?
• The economic cycle across the euro area countries
appears to be positively correlated – the timing of
booms and recession seems to be very close.
• There is no clear evidence of asymmetric shocks
affecting these countries.
• However, a problem remains in that some
countries may have a persistently higher rate of
growth than others.
• Ireland over the period 1994-2002 provides an
example.
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Figure 4 Growth Rates in Ireland and the Whole
Euro Area
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Is Europe an Optimum Currency
Area?
• There is no clear-cut answer to the question.
• Perhaps the only true test of whether Euroland
is an OCA is to see whether it survives in the
long run.
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Fiscal Policy and Common
Currency Areas
• Fiscal federalism is a fiscal system for a group
of countries involving a common fiscal budget
and system of fiscal transfers across countries.
• If a currency union had a common fiscal policy
then fiscal policy in the currency union would
work much as fiscal policy in a single national
economy works.
• The problem might be that taxpayers in one
country may not be happy to see their taxes
spent on transfers to residents of another
country.
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Fiscal Policy and Common
Currency Areas
• In the absence of fiscal federalism there is a potential free
rider problem.
• Whenever a government raises it levels of debt to very
high levels there is a possibility that the government may
default on the debt.
• Generally the financial markets will charge higher rates of
interest to lend to a government that runs up large debts.
• Inside a currency union, it might be expected that the other members of
the union will bail out a government that has borrowed heavily, rather
than see it default.
• If the financial market takes this view, then the interest rate penalty
imposed on the high borrowing government will be less.
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Fiscal Policy and Common
Currency Areas
• Because all the other governments are regarded as
underwriters of the high borrowing government’s debt, they
will all face higher interest rates on their borrowing than they
otherwise would.
• Thus, the high borrowing government borrows more cheaply
than it could outside of the currency union, and imposes costs
on the other currency union members.
• Currency union members can enter into ‘no bail-out’
agreements, but there is an issue about the credibility of such
agreements.
• So a set of fiscal rules may be used instead. At the outset of
EMU, just such a set of rules was drawn up, known as the
Stability and Growth Pact (SGP).
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Fiscal Policy and Common
Currency Areas
• The main components of the SGP were:
• Members should aim to achieve balanced budgets.
• Members with a budget deficit of more than 3 per cent
of GDP would be subject to fines of up to 0.5 per cent
of GDP unless the country was experiencing
exceptional circumstances or a recession in which GDP
declined by 2 per cent or more in a single year.
• The choice of a maximum budget deficit of 3 per cent
of GDP was related to the clause in the Maastricht
Treaty that suggested the debt-to-GDP ratio should be
no more than 60 per cent.
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Fiscal Policy and Common
Currency Areas
• While there is some logic to this, it is not clear why the
SGP suggested that members should aim for balanced
budget.
• The crucial question was whether the maximum allowable
budget deficit would be enough to allow the automatic
stabilizers come into play when an economy enters a
recession.
• The early years of EMU were years of sluggish GDP growth
and several countries found themselves with budget deficits
in excess of the SGP limit, including both France and
Germany.
• These countries then managed to persuade other EMU
members not to impose fines, and in 2004 the European
Commission drew up guidelines for softening the SGP.
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Fiscal Policy and Common
Currency Areas
• Having a system of rigid rules and fines, but no
credible way of enforcing the sanctions, was
not the correct way to ensure fiscal stability in
the euro area.
• Now the system effectively relies on peer
pressure and concern for national prestige – no
country wants to be seen as profligate and
irresponsible.
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Summary
• A common currency area (a.k.a. currency union or
monetary union) is a geographical area through which
one currency circulates and is accepted as the medium of
exchange.
• The formation of a common currency area can bring
significant benefits to the members of the currency
union, particularly if there is already a high degree of
international trade among them (i.e. a high level of trade
integration).
• This is primarily because of the reductions in transaction
costs in trade and the reduction in exchange rate
uncertainty.
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Summary
• There are, however, costs of joining a currency union,
namely:
• the loss of independent monetary policy
• and the loss of the exchange rate as a means of
macroeconomic adjustment.
• These adjustment costs will be lower the greater is the
degree of real wage flexibility, labour mobility and
capital market integration across the currency union,
and also the less the members of the currency union
suffer from asymmetric demand shocks.
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Summary
• A group of countries that has a high level of trade
integration, high labour mobility and real wage flexibility,
a high level of capital market integration and whose
member countries do not suffer from asymmetric shocks, is
termed an optimum currency area (OCA).
• An OCA is most likely to benefit from currency union.
• It is possible that a group of countries may become an
OCA after becoming a currency union, as having a
common currency may further enhance trade integration,
thereby helping to synchronize members’ economic cycles,
and having a single currency may also help to foster
increased labour mobility and capital market integration.
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Summary
• The current euro area displays, overall, a high degree
of trade integration and does not appear to be plagued
by asymmetric demand shocks, but real wage
flexibility and labour mobility both appear to be low.
• Although the introduction of the euro has led to a high
degree of Euroland financial market integration at the
wholesale level, retail financial markets remain
nationally segregated.
• Overall, the euro area is probably not at present an
optimum currency area, although it may eventually
become one.
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Summary
• The problems of adjustment within a currency union that
is not an OCA may be alleviated by fiscal federalism – a
common fiscal budget and a system of taxes and fiscal
transfers across member countries.
• In practice, however, fiscal federalism may be difficult
to implement for political reasons.
• Having separate national fiscal policies in the countries
making up a currency union may give rise to a free rider
problem.
• It is for this reason that a currency union may wish to
impose rules on the national fiscal policies of its
members.
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