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Which countries were European Union members as of 2003? • • • • • • • • • • France Belgium Netherlands Luxembourg Italy Spain Portugal Greece United Kingdom Ireland • • • • • • • • • Denmark Sweden Norway Finland Germany Switzerland Austria Cyprus Turkey Which countries became EU members in 2004? • • • • • • • • Turkey Cyprus Malta Hungary Poland Czech Republic Slovakia Romania • • • • • 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 competitioncut 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 – – – – – 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 • • • • 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 • Duisenberg “too blunt”, Trichet “chooses his words more carefully” – Analysts disagree about whether Trichet will alter strategy of 2% inflation target • • 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