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Which countries were European
Union members as of 2003?
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France
Belgium
Netherlands
Luxembourg
Italy
Spain
Portugal
Greece
United Kingdom
Ireland
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Denmark
Sweden
Norway
Finland
Germany
Switzerland
Austria
Cyprus
Turkey
Which countries became EU
members in 2004?
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Turkey
Cyprus
Malta
Hungary
Poland
Czech Republic
Slovakia
Romania
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Latvia
Estonia
Lithuania
Bulgaria
Slovenia
Forms of Economic Integration
• free trade area - free movement of goods and
services between member countries
• Example: NAFTA
• customs union = free trade area + common
external trade barriers
• Example: Mercosur (Brazil, Argentina, Paraguay, Uruguay)
• common market = customs union + free
movement of labor and capital
• Example: European Union after Single Market Program
• economic union = common market + common
currency (
common monetary policy and
coordinated fiscal policies)
• Example: European Union after Maastricht Treaty
Forms of Economic Integration
• free trade area - free movement of goods and
services between member countries
• Example: NAFTA
• customs union = free trade area + common
external trade barriers
• Example: Mercosur (Brazil, Argentina, Paraguay, Uruguay)
• common market = customs union + free
movement of labor and capital
• Example: European Union after Single Market Program
• economic union = common market + common
currency (
common monetary policy and
coordinated fiscal policies)
• Example: European Union after Maastricht Treaty
Chronology of European
Integration
• 2 problems after WWII:
– Economic reconstruction
– History of German-French hostility
• Technical cooperation: European Coal &
Steel Community (1951)
• Free trade area: Treaties of Rome (1957)
• Customs Union (1967)
Legacy of segmented markets
(pre-Single Market Program)
Markets segmented by protection - technical,
physical and fiscal barriers - leading to:
• Pattern of “national champions”
• Lack of economies of scale (high unit costs)
• Overcapacity, overstaffing
• Low incentive to innovate, invest
• Unresponsive to customers & market changes
Not globally competitive, so seek protection…
A vicious cycle...
that can be broken by
the dynamic benefits of economic integration
Common market: the
Single Market Program
• “Eurosclerosis” of early 1980s
– Lack of global competitiveness
– Lack of progress towards higher level of integration
– Euro-standards mentality
• 1987 Single European Act
– Mutual recognition
– 1992 target date
• Philosophy – dynamic benefits:
– Economies of scale
– More competitioncut costs, innovate,
respond to market
Result:
increased
global
competitiveness
Broadening
of membership
• Original Six: France, Germany, Italy,
Belgium, Netherlands, Luxembourg
• 1973 - U.K., Ireland, Denmark
Note: geographic
alternation between
• 1981 - Greece
richer (northern)
and poorer
• 1986 - Spain, Portugal
(southern, eastern)
• 1995 - Austria, Sweden, Finland countries
• 2004 – 10 new members from Eastern
Europe and the Mediterranean
Rationale for a single
currency in Europe
• Logical extension of the 1992 Single
Market Program
– Exchange rate fluctuations as barriers to a
single market
– Growing percentages of intra-Community trade
– Further increase global competitiveness by
reducing costs faced by European firms
Background: post-WWII
European exchange rate
arrangements
• Bretton Woods: gold-dollar fixed exchange
rate system
• Werner Report (1970)
• Breakdown of Bretton Woods System
• Snake (1974)
– “snake in the tunnel”
– “snake in the lake”
EMS - European
Monetary System (1979)
• Fixed exchange rate system
• Components of EMS
– European Currency Unit (ECU)
– Exchange Rate Mechanism (ERM)
– Intervention funds
• EMS track record
– Realignments (devaluations and revaluations)
– Macroeconomic convergence
Rationale for a
single currency (cont’d)
• Apparent success of EMS: stable exchange
rates, converging economic performance
• Fixed exchange rates w/o capital controls
are vulnerable to speculation
• Public enthusiasm for Single Market
• Politics - bind unified Germany to western
Europe
Maastricht plan for EMU
(Economic and Monetary Union)
• 1991 Maastricht Treaty criteria
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Government deficit 3% of GDP
Government debt 60% of GDP
Inflation 3% per year
Convergence of long term interest rates
Everyone in ERM, no realignments for 2 years
• Original timetable for single currency:
– All countries meeting the criteria join in 1997
– All other countries join in 1999
Exchange rate crises
• September, 1992 crisis
– Precipitating factors: French referendum on
Maastricht, high German interest rates
– Outcome: UK, Italy left ERM
• July-August, 1993 crisis
– Precipitating factors: European recession, high German
interest rates
– Outcome: bands of fluctuation widened from 2.25%
to 15%
• Lesson: EMS vulnerable w/o capital controls
Revised timetable for EMU
• 1992, 1993 currency crises pushed back timetable
• 1998 conference to determine which countries
qualified, set conversion rates
– Creation of European Central Bank (ECB)
• Choice of head of ECB: Wim Duisenberg
• France preferred Jean-Claude Trichet
• January 1, 1999 - start of EMU
C
– Exchange rates with euro irrevocably fixed
– Euro is introduced and co-exists with legacy currencies
• Jan. 1, 2002 - euro notes and coins circulate
• Early 2002 - national currencies disappear
Euro-zone:
who’s in, who’s out
Countries that are in
Austria
Belgium
Finland
France
Germany
Greece
Joined 1/1/01
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
Countries that are out
Rejected euro in 2000
Denmark
referendum; polls show
support but no new
Sweden
referendum yet
U.K.
Referendum in
September 2003;
No’s won
5 tests show UK
not ready; future
referendum in
doubt
Technically, the launch of the
euro was a great success
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European Central Bank
Contracts
Stock and bond markets
Public acceptance
But the euro lost a lot of value in
the first 2 ½ years:
Explanations for
the euro’s fall
• Rates of return in US vs. euro-zone
– Interest rates
– Stock markets
• Rates of economic growth and productivity
• Central bank credibility
Then the euro reversed direction:
Sep 2004
Explanations for
the rise in the euro
• Rates of return in US vs. euro-zone
– Interest rates
– Stock markets
• Rates of economic growth and productivity
• Central bank credibility
US and Euro-zone 3-month interest rates (interbank)
8
7
6
percent per annum
5
4
3
2
1
0
07/24/1998
Source: Datastream
12/06/1999
04/19/2001
09/01/2002
Euro-zone interest rate
US interest rate
01/14/2004
05/28/2005
Monetary policy –
Euro-zone and US compared
• Who makes monetary policy decisions?
• How are these decisions communicated?
• What is the central bank’s mandate?
• How are monetary and fiscal policy coordinated?
ECB’s policy challenges
• Balancing European and national economic needs
– Divergent economic performance
• Have seen higher inflation in peripheral countries like Ireland
and Spain since euro launch
• Growth has been slow in core countries like Germany
– Critics: over-emphasis on fighting inflation neglects
economic growth effects of monetary policy
• Consensus decision-making
– Critics: decisions are made too slowly
– ECB: we don’t fine-tune as much as US; we realize
policy takes a long time to have an effect
ECB’s policy challenges (2)
• Communicating monetary policy – getting
the “code” right
– Credibility
– Consistency
– Transparency
• Critics: too secretive, should publish minutes
• ECB: we do not want policy to be interpreted as
politically motivated
ECB’s policy challenges (3)
• ECB Succession – Jean-Claude Trichet took over
November 1, 2003
– Cleared in Credit Lyonnais scandal
• Will Trichet make a difference?
– Trichet a “more forceful” personality
– May be better communicator
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Duisenberg “too blunt”, Trichet “chooses his words
more carefully”
– Analysts disagree about whether Trichet will alter
strategy of 2% inflation target
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He was tough on inflation at Banque de France
Well-connected with central bankers who believe best
practice is to support economic growth + fight inflation
Fiscal policy
in the euro-zone
• Fiscal policy governed by “Stability Pact”
– Fiscal policy coordination necessary in order to
have a single monetary policy
– Pact: budget deficits cannot exceed 3% of GDP
• Punishment for violations: public reprimand, fines
(of up to 0.5% of GDP)
• Exceptions in cases of recession
– Germany was biggest supporter of pact
Stability Pact in practice
• Expected that smaller, “weak currency” countries
would have most trouble with the stability pact
– But it’s France and Germany whose budget deficits
have been too big the last few years
• France has resisted deficit reduction, citing slow
growth
– Undermines credibility of Stability Pact;
– Looks like big countries are treated differently
• When Portugal breached limit in 2001, it was forced to reduce
its deficit
Stability Pact
in practice (2)
• European Commission and ECB urged Stability
Pact compliance for France & Germany
• Nov 2003: finance ministers agreed France &
Germany could cut less than Commission wanted
– Gave France, Germany until 2005 to meet 3% limit
– Effectively suspended Stability Pact
– Ministers were split: Spain, Austria, Finland,
Netherlands opposed agreement
Stability Pact in practice (3)
• Commission challenged ministers’ agreement in
court
– In July 2004 European Court of Justice ruled:
• Council of Ministers may not suspend the Pact
• However, Council may reject Commission’s recommendations
and interpret the Pact its own way
• 6 countries likely to go over deficit limit in 2004
– Germany says it’s likely to breach limit in 2005, too (4th
consecutive year)
• Looks like Pact will be revised; Commission has
proposed some ideas (see below)
Revising the Stability Pact
• General principle:
– Cannot reduce fiscal policy to a single variable (budget
deficit) and a single number (3%)
• Ideas proposed by Commission in Sept. 2004
– Relate rules to business cycle: can run bigger deficits in
recession but must run surpluses during expansion
– Look at medium/long term debt sustainability
• Relate to economic growth, future pension liabilities, etc.
– Rely more on consultation, peer pressure than rules
• Differences of opinion
– Germany opposes weakening pact, sees fiscal prudence
as necessary to avoid inflation
– ECB opposes changing pact