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320.326: Monetary Economics
and the European Union
Lecture 9
Instructor: Prof Robert Hill
Monetary Union in the EU
De Grauwe – Chapters 7, 8, 9
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1. The Maastricht Treaty
The treaty signed in 1991 set the rules for monetary union 12
years later.
Entry into the monetary union was made conditional on
satisfying convergence criteria.
A country would be eligible to join the union only if:
(i) its inflation rate was not more than 1.5% higher than the
average of the three lowest inflation EU countries.
(ii) its long-term interest rate was not more than 2% higher than
the average of the same three lowest inflation EU countries.
(iii) it has joined the exchange rate mechanism (EMS) and has
not experienced a devaluation during the two years prior to
entry.
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(iv) the government budget deficit is not higher than 3% of GDP
(or it must be declining steadily and come close to 3%, or it
must be above 3% only because of some exceptional event).
(v) Government debt does not exceed 60 percent of GDP (if it
does it should show a clear downward trend towards 60
percent).
In 1998 it was decided that 11 countries satisfied the conditions
for membership (and also wanted to join). Greece soon after
also satisfied the conditions.
Note: it has emerged since that the Greek statistics were
“massaged” to meet the criteria.
The UK, Sweden and Denmark satisfied the conditions but
chose not to join.
Slovenia joined the Eurozone in 2007, Cyprus and Malta in
2008, Slovakia in 2009, Estonia in 2011 and Latvia in 2014.
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Technically, monetary union started in 1999. At this point, the
exchange rates of the member countries were fixed. The Euro
(notes and coins) came into effect in 2002.
The national central banks of the member countries continue to
exist. They maintain their decision making powers over banking
supervision, and assist the ECB with the implementation of
monetary policy.
2. Why Convergence Requirements?
(i) Inflation convergence to a low level
There was a desire (particularly in Germany) to ensure that the
European Central Bank (ECB) would take a strong stance against
inflation.
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The inflation convergence criterion was a way for the member
countries to show their commitment to low inflation.
If all members of the Eurozone have similar inflation rates, this
makes things easier for the ECB.
Unfortunately, some members countries had systematically higher
inflation (which was not matched by faster growth in productivity)
year after year, and hence became less competitive.
Becoming less competitive year after year while simultaneously
running up a large government debt (e.g., in Greece and Italy) is a
dangerous combination that may end in the government defaulting
on its debt.
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(ii) Budget convergence and debt levels
Large budget deficits over time lead to large government
debts. A government with a large debt has an incentive to
inflate it away. The inflation fighting credibility of the
monetary union will be greater if the government debts of the
member countries are not too large.
Or a country with a large debt might default which could also
undermine the credibility of the Euro zone. A default might
then spread contagion since the holders of these bonds (often
banks from other countries) may also get into difficulty.
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Why should the limit in the Maastricht treaty be a budget deficit of
3% and government debt of 60% of GDP?
The upper debt limit is equal to the average debt to GDP ratio of
the EU countries in 1992.
The government debt as a percentage of GDP (b) can be stabilized
even while the government runs a deficit (d) if the growth rate of
GDP (g) is high enough.
b will be stable if d=gb (see de Grauwe page 148 footnote 5 for a
derivation of this result).
For example, suppose the government’s debt level is 60%, and GDP
is growing by 5% per year. We obtain that d = 0.05 × 0.6 = 0.03.
That is, the government can run a 3% deficit without increasing b,
when b=0.6 and g=0.05. Is assuming g=0.05 realistic?
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The main concern with the deficit and debt criteria was that
excessive deficits and debt might be inflationary.
There was not much if any discussion of how excessive debt
could cause governments to default on their debt.
In retrospect, if all countries had stuck to the Maastricht
criteria, then the Euro-zone crisis would not now be as severe
as it is now. The Maastricht criteria however would not have
prevented the crises in Ireland and Spain (see previous
lecture).
Some prominent economists (e.g., Krugman and Buiter) were
critical of the deficit and debt levels set by the Maastricht
Treaty, saying they were arbitrary and did not allow countries
to run big enough deficits during recessions.
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3. Expansion of the Euro-Zone
Slovenia joined the Euro-zone in 2007, Cyprus and Malta in 2008,
Slovakia in 2009, Estonia in 2011 and Latvia in 2014. Lithuania
was refused entry in 2007 since its inflation rate was 2.7%.
The average inflation rate of the three lowest inflation countries in
the EU (inflation was lowest in Sweden – a non-Eurozone country)
was 1.1%. Lithuania failed to reach the inflation target by 0.1%.
Half the Euro-zone countries had inflation rates higher than
2.7 percent – Spain (3.3%), Greece (3.4%), Ireland (3.7%),
Luxembourg (3%), the Netherlands (2.7%), Portugal (3.1%).
2.7% is as close to the ECB’s “just under 2% target” as 1.1% is.
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Also, not all the original Euro-zone members satisfied all the
criteria on entry – e.g., Belgium, Italy and Greece had debts
levels that exceeded 100 percent of GDP (but were moving
in the right direction). Also, Germany’s debt level exceeded 60%
and was rising.
Hence Lithuania has been harshly treated. This may be because
of a fear that further expansion of the Euro-zone could cause it
to cease being an optimal currency area.
4. The Design of the ECB
The ECB has a mandate to maintain price stability and stabilize
output and employment (provided the latter does not endanger the
former).
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The ECB is less accountable than the Federal Reserve. The
chairman of the Federal Reserve must testify before Congress
periodically. Congress has the power to change the statutes of
the Federal Reserve with a simple majority vote.
The president of the ECB must testify before the European
Parliament (EP). The EP however does not have the power to
change the statutes of the ECB. These can be changed only
through a change of treaty that requires a unanimous vote by
all EU member states.
There is an absence of strong political institutions in Europe
capable of exerting control over the ECB.
This and the vagueness of the Maastricht Treaty has allowed the
ECB to redefine its objective as simply one of price stability.
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The ECB is hence the most independent central bank.
The ECB is also not very transparent. The minutes of the
meetings of the Governing Council are not made public and it
does not admit to having an explicit inflation target.
Mario Draghi, the current ECB president, has reoriented the
ECB’s focus during the Eurozone crisis “to do what it takes to
save the Euro”. This has entailed providing liquidity to banks
even at the risk of creating inflation in the future.
5. The Problem of Large Budget Deficits and Debts
Greece’s budget deficit in 2011 was 9.5 percent of GDP and its
debt was about 165 percent of GDP, well above the upper limits
set by the Maastricht treaty.
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Inflation in Eurozone
Source: ECB
Budget balance as a percentage of GDP
End 2011
End 2012
End 2013
USA
-8.7%
-7.0%
-4.1%
China
-1.8%
-2.3%
-2.0%
Japan
-8.3%
-9.7%
-8.2%
UK
-8.8%
-7.9%
-6.7%
Norway
+13.1%
+13.4%
+13.0%
Saudi Arabia
+14.3%
+12.6%
+6.0%
===========================================
Austria
-3.6%
-2.5%
-2.9%
France
-5.8%
-4.5%
-4.1%
Germany
-1.0%
-0.2%
+0.1%
Greece
-9.5%
-7.0%
-2.2%
Italy
-4.0%
-2.8%
-3.2%
Netherlands
-4.2%
-4.2%
-3.5%
Spain
-6.5%
-8.3%
-7.1%
(Source: The Economist)
Government debt in the Euro area and USA (%
of GDP)
Source: European Commission, European Economy.
Fourteen EU Member States had government debt ratios higher
than 60% of GDP at the end of 2011:
Greece (165.3%), Italy (120.1%), Ireland (108.2%), Portugal
(107.8%), Belgium (98.0%), France (85.8%), the United
Kingdom (85.7%), Germany (81.2%), Hungary (80.6%), Austria
(72.2%), Malta (72.0%), Cyprus (71.6%), Spain (68.5%) and
the Netherlands (65.2%).
(Source: Bloomberg Businessweek)
How did Greece accumulate such a large debt?
Banks and other market participants thought that Greek bonds
were less risky once it joined the Euro. They thought there was
no risk of depreciation and that no Eurozone country would
default on its bonds.
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The Greek government was hence able to borrow much more
that it otherwise could have and at much lower interest rates.
The Greek government put short term gain ahead of long term
sustainability - (a good example of dynamic inconsistency) and
borrowed too much.
The loss of competitiveness of the Greek economy after joining
the Euro has now sent Greece into recession, thus further
increasing the debt-to-GDP ratio.
Attempts to reduce the government deficit are worsening the
recession in Greece.
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Implications of default by Greek government
It depends on who holds Greek bonds? In October 2011, most
were held by commercial banks, mutual and pension funds,
sovereign wealth funds (SWFs) and central banks.
Commercial banks in Germany and France were particularly
exposed.
Note: the EU/IMF portion of the pie chart (next slide) is in the
form of direct loans rather than bonds. This is therefore
unaffected by a bond default.
Private holders of Greek bonds have accepted a 50 percent
haircut.
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October 2011
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Source: Ben Chu, The Independent, 17 Oct 2011
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The 50 percent haircut has not helped Greece as much as one
might think, since Greek banks and funds held a lot of the bonds.
The Greek government may be forced to bail out these banks and
funds hence adding again to its debt.
By the end of 2012, private sector holdings of Greek bonds had
fallen quite a bit. Also, hedge funds had moved in to the market
(buying bonds at steep discounts) in search of quick profits.
According to the New York Times (23 Dec 2012) some hedge
funds earned 100 percent returns on Greek bonds in 2012. They
bought at low prices and bet on EU intervention that caused a
partial rebound of prices.
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6. The Organizational Structure of the ECB
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The Governing Council is the main decision making body of
the ECB. It consists of the executive board of the ECB
(president, vice-president, and four directors) and the
governors of the 15 national central banks in the Euro-zone.
The Governing Council makes decisions on monetary policy,
interest rates, reserve requirements, and the provision of
liquidity.
It meets every two weeks in Frankfurt. Each member of the
Council has one vote.
The Executive Board sets the agenda for meetings of the
Council, and implements monetary policy decisions
(including giving instructions to the national central banks).
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Under ECB rules, board members do not represent a particular
country, nor are they responsible for keeping track of economic
conditions in one country. All board members are jointly
responsible for monetary policy for the entire Euro area.
The whole framework described in Figure 8.10 is called the
Euro-system.
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This system may become more problematic with enlargement
of the Euro-zone. The influence of the ECB executive board
could be reduced too much, making it vulnerable to capture
by regional blocks.
Also, smaller countries may exert too much weight (compared
with their contribution to Euro-zone overall population).
In 2002, the Governing Council agreed that the number of
governors with voting rights will be limited to 15, and that
voting rights will rotate, with countries with larger
populations voting more frequently now that membership
exceeds 15.
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7. Monetary Policy in the Euro-zone
The desired interest rates according to the Taylor rule for each
Euro-zone country in 2005 are shown in Figure 9.7. The
corresponding inflation rates and output gaps are shown in
Figures 9.5 and 9.6.
Note: a Taylor rule determines the target interest rate as a
function of the inflation rate and output gap.
rt* = ρ + πt + a(πt – π*) + b xt
where a,b>1
r* = target interest rate, π* = target inflation rate, π = actual
inflation rate, x = output gap (i.e., y-yn), ρ = long term real
interest rate.
Here we set a=1.5, b=0.5, ρ = 2% and π* = 2%.
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The Taylor rule is particularly useful in situations where
inflation is above its target level and the output gap is negative
(i.e., stagflation).
The spread in desired interest rates (according to the Taylor
Rule) is quite large, ranging from just under 2% (the
Netherlands) to 7% (Greece). With such a large spread, it is
impossible for the ECB to find an interest rate that suits everyone.
Inflation is highest relative to its natural rate for the lower
income members of the Eurozone.
This is consistent with the convergence of income levels in the
Eurozone. More rapidly rising wages in the lower income
countries causes the price of nontradables to rise faster and
hence inflation to be higher.
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But has productivity risen with wages in these countries?
The too low interest rates in some of the poorer EU countries may
have helped trigger housing booms (Ireland and Spain are
prominent examples) and/or inflation and hence a loss of
competitiveness (Greece and Italy).
See Figure B17.2.
A cross-section regression of real interest rates against house price
changes further supports this hypothesis.
See Figure B17.3.
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