Download Applied Economic Policy Course 14 L

Joining a Monetary Union:
Europe’s Great Monetary Experiment
Eduard Hochreiter
Joint Vienna Institute
Wilfrid Laurier University
Thursday, September 27, 2007
3.00 p.m.
1
Overview
1.
2.
3.
4.
5.
6.
7.
8.
9.
Introduction
A Look at History
The Architecture of Maastricht incl
Coordination of Macro Policies
Benefits and Costs of Joining a MU
Institutional Requirements for Joining EMU
Economic Issues Regarding The Adoption
of the Euro
The Adoption of the Euro: The Case of
Greece
Experiences with EMU
Some general conclusions
2
1. Introduction






Exciting experiment
born out of will to prevent wars
nourished by market integration
entering adulthood with the introduction of the
euro
complex political – institutional – economic
interaction; European integration perspective 
difference to other regions
lecture pinpoints important institutional &
economic issues
3
2. European Integration –
Europe’s Great Monetary Experiment –
A Brief Look At History - 1
1950:
1952:
1957:
1958:
1960:
1970:
1972:
1979:
1986:
1990:
1992:
1993:
European Payments Union (EPU)
European Coal and Steel Community (ECSC)
Treaty of Rome
European Economic Community (EEC) + EURATOM
European Free Trade Association (EFTA)
„Werner Report“: Create EMU within a Decade
„European Currency Snake“
European Monetary System (EMS)
Single European Act
Stage 1 of EMU
Maastricht Treaty
Single Market for „Four freedoms“ a reality
4
2. European Integration –
Europe’s Great Monetary Experiment –
A Brief Look At History - 2
1994:
Stage Two of EMU; EMI (European Monetary Institute)
1995: Fixing of starting date of Stage Three of EMU; “Euro”
1997: Amsterdam Treaty - SGP
1998: ECB; decision on 11 initial EMU members
1999: Stage Three of EMU
2001: Greece: 12th Euro Area-member
2002: Issuance of euro coins and banknotes
2004: Ten new EU-MS, mainly from CEE
2007: BG + ROM join EU; Slovenia 13th Euro Area-member
2008: Cyprus and Malta:14th and 15th Euro Area-member
2009: Slovakia becomes the 16th Euro Area-member?
Back
5
Back
Back
Back
6
3. The Architecture of the Maastricht
Model - 1
Historical uniqueness of EMU:
National states formally give up sovereign
monetary policy in peacetime and transfer it
to a supranational, independent institution
the ESCB.
Maastricht Treaty (MT): Price stability as basic
common public good of the EU. The MT
enshrines the European “stability culture”.
7
3. The Architecture of the Maastricht
Model - 2

Amsterdam Treaty: SGP
SGP clarifies and modifies EDP
+ establishes an early warning system by setting
up yearly stability programs to be submitted by
MS
+ defines medium term budgetary objective of
“positions close to balance or in surplus
+ sets strict deadlines for the application of the
EDP
+ invites the imposition of sanctions

Reform of the SGP 2005
8
Reform of the SGP 2005
-1

3% (for budget deficit) and 60% (for public debt) reference
values remain unchanged.
“Preventive arm“ changes:
+ Medium term objective “close to balance or in surplus”
(CTBOIS) zero to surplus  broadened to – 1% (high growth
low debt countries) to zero to surplus (low growth high debt)
and CTBOIS now country-specific
Implies: European Commission now more room for discretion
and interpretation
+ More symmetric  “consolidation in good times”
+ No EDP when G-deficit > 3%, if overshooting due to
temporary factors and “remaining close to the reference value”
 Long list of temporary deviations from MT objective (e.g.:
structural reforms)
9
Reform of the SGP 2005
-2
“Corrective arm” changes:
+ No triggering of EDP, if economic growth contracts by more
than 2%.
 Broadened to" negative growth or a period of low growth”
+ Long list of exceptional circumstances, e.g.: cyclical
position, R&D, financial contributions to foster international
solidarity, the unification of Europe, etc.
+ Minimum fiscal adjustment 0.5% p.a., if not CTOBOIS
+ Extension of deadlines of EDP
+ Repeating of procedural steps possible
+ Extension of correction period  2 years (Portugal 3
years already!!)
Back
10
3. The Architecture of the Maastricht
Model - 3
Monetary Policy centralized at euro area level and oriented
towards an area-wide objective: the maintenance of price
stability (defined by the System itself).
Fiscal Policy predominately remains in the national domain,
subject to the Treaty constraint that national economic
developments must not influence monetary conditions in the
euro area in a negative way.
GUIDING PRINCIPLES:
 “sound public finances” [Art 4(3)]; economic policies a
matter of common concern (Art. 99)
 No bailout clause (Art. 103)
 EDP (Art. 104) --- Maastricht Treaty
 SGP (Council Regulations 1466/97, 1467/97 and Council
Resolution 97/C236/01-02) --- Amsterdam Treaty
11
3. The Architecture of the Maastricht
Model - 4
2 major issues:
 Question: Are there sufficient incentives for sound
fiscal policies in EMU AFTER the adoption of the
euro?



What are “sound”, i.e. sustainable fiscal policies?
Fiscal rules and coordination among fiscal policies
Question: How to secure the consistency of (only
loosely coordinated) national fiscal policies with the
area-wide stability-oriented monetary policy.

Is there a case for ex ante coordination between fiscal
and monetary policies?
12
3. The Architecture of the Maastricht
Model:
What are sound, i.e. sustainable fiscal policies?



bt  ( gt  tt )  (it  y y )bt  mt

bt
= change in government debt at time t
g
= government expenditure exclusive of interest payments
t
= government revenue except seigniorage

(it  y y )
= „net“ interest payments, i.e. difference between the nominal
interest rate and nominal GDP growth

mt
= change in monetary base = seigniorage
Back
13
3. The Architecture of the Maastricht
Model - 5

(ad 1): Potential conflicts among national fiscal
policies. How to discipline fiscal policy? Do we
need fiscal rules in EMU?



Problem 1: excessive deficits in one region spread over
the union: incentive for governments to overspend (in SR)
 externalization of fiscal excesses [smaller rise in
interest rate]: FREE RIDING PROBLEM
Problem 2: if so, bailout? (in LR) to avoid bankruptcy 
potential cost of bailout spread over the union [smaller
rise in inflation]: MORAL HAZARD PROBLEM
HENCE:  (binding) fiscal rules (of some kind, e.g.
SGP) recommended on economic grounds to avoid
lax fiscal policies.
14
3. The Architecture of the Maastricht
Model - 6
Coordination of fiscal and monetary policies:

The economics debate: How are fiscal and monetary
policies related?
Monetary and fiscal policy are linked through the
intertemporal budget constraint (expected sum of
expenditure = exp. sum of revenues); in EMU
seigniorage is exogenous for govt.; hence budget
constraint must be met in LR to avoid bankruptcy.
15
3. The Architecture of the Maastricht
Model - 7

What does theory tell us regarding the
benefit/need to ex ante coordinate fiscal and
monetary policy?


In simple two-player game theoretic models it can be shown
that policy coordination improves the policy outcome (move
from non-cooperative to bargaining equilibrium raises
welfare; reduction of spillover effects)
BUT: Who takes the lead in fiscal policy in EMU? Will all the
other (fiscal) players fall in line? Are all players
symmetrically informed? Is the economic model agreed?
How sizeable are the welfare gains?
 Many uncertainties!
16
3. The Architecture of the Maastricht
Model - 8

Is there a need for fiscal rules?
+ Static macro model: IS-LM are independent
 NO
+ Neoclassical perspective: if Riccardian equiv. holds or, if not,
financial markets are efficient (sovereign credit risk is reflected in
risk premia)  NO
+ Dynamic macro model = Maastricht Model: UMA (SargentWallace) turns into UFA (Winckler-Hochreiter-Brandner)  YES
+ Fiscal theory of the price level: in the case of a fiscal shock
monetary policy, ultimately, must produce enough (inflation tax)
revenue for the state to remain solvent (see formula above) =
fiscal dominance  NO
ALTERNATIVELY: reduce G or raise T to secure the LR solvency
of the state (see formula above) = monetary dominance
17
3. The Architecture of the Maastricht
Model - 9
Fiscal policy surveillance and coordination:

Multilateral surveillance of fiscal policies:
European Commission

Coordination through ECOFIN = institutional
flaw as ECOFIN decides on existence of ED, the
measures to be taken and the sanctions levied!
Central instrument of policy coordination: BEPGs
under the Mutual Surveillance Procedure (Art.
99)
 comprises the guiding principles of economic
policy making in a medium term perspective of
3 years for the EU, euro area and each MS.
Back
18
4. Benefits and Costs of Joining a MU
-1Benefits:
 Lower transaction costs (OCA)  trade effects
(beyond that of fixed exchange rates) – Rose 2000,
Glick & Rose 2001, Frankel & Rose 2002.
 Other micro efficiency gains (no exchange rate risk;
lower interest rate differential; deeper financial
integration; seigniorage gain through international use
of currency (€).
 Higher business cycle sycronicity  endogeneity of
OCA
 More real growth and reduced output and inflation
variability
19
4. Benefits and Costs of Joining a MU
-2Costs:




Loss of monetary policy instrument
Loss of seigniorage
Higher real exchange rate persistence
Cost of asymmetric shocks
20
4. Benefits and Costs of Joining a MU
-3
Assessment for Europe (Hochreiter et. al, 2002, Table 2).
BENEFITS:





savings on transaction costs: (EC 1990: forex + interbank
transactions: + 0.5% p.a.; R. Mendizábal 2006: + 0.69% p.a.
max.)
other micro gains: all positive impact on growth; most: financial
deepening  substantial growth effects: > + 0.5% p.a.
higher BC synchronization (Böwer and Guillemineau 2006; and
lower volatility (EC 2007).
growth benefits beyond that of fixed exchange rates through
single currency  „Rose Effect“, i.e. tripling of trade (Rose
2000), + 30 to + 90 % trade growth for Euro Area (Rose and
Stanley 2005).
additional seigniorage through international use of currency 
small
21
4. Benefits and Costs of Joining a MU
-4COSTS:
 loss of autonomy for monetary policy: can also be
a blessing (e.g., Greece; Hochreiter & Tavlas
2005);
 asymmetric shocks: negligible for most EU
members; but, possibly size-related (sticky
domestic adjustment mechanisms).
 (Net) Loss of seigniorage: negligible, if at all.
Back
22
5. Institutional Requirements of The
Adoption of the Euro:
The Maastricht Convergence Criteria - 1




EMU membership is part of the legal EU Treaty
framework, the "Acquis communitaire".
Hence, with EU entry also EMU and ESCB
membership, but “with a derogation”
Euro adoption a right AND a Treaty obligation
(no opt-out clause)
precondition for euro adoption: fulfillment of
Maastricht convergence criteria
23
5. Institutional Requirements of The
Adoption of the Euro:
The Maastricht Convergence Criteria - 2
1.
1.
Inflation criterion: an (sustainable) inflation rate not
more than 1 1/2% higher than those of the three best
performing EU countries (EU 27!!) over the latest 12
months.
 Does this make sense in EMU?
Fiscal convergence criteria:
(a) a general government budget deficit of not more
than 3 % of GDP, unless either the reference value
was exceeded only temporarily or exceptionally and
remains close to the reference value, or the ratio has
declined substantially and continuously and reached a
level close to the reference value.
 Too restrictive? not enough room for
manoeuvre? Procyclical?
24
Derivation of 3% deficit reference
value:
where
d =
bp =
b =
i =
r =

p =
gep=
g =
t =
level of debt
primary balance
overall balance
nominal interest rate
real interest rate
rate of inflation
government expenditure
real growth rate
taxes
Back
25
5. Institutional Requirements of The
Adoption of the Euro –The Maastricht
Convergence Criteria - 3
(b) a government debt ratio of not more than 60 % of
GDP unless the ratio is approaching that level at a
satisfactory pace.
 not enough emphasis on level of debt?
3. Interest rate criterion: an average nominal long term
interest rate that does not exceed by more than two
percentage points that of the three best performing
member states in terms of price stability.
 not really controversial
4. Exchange rate criterion: participation in the Exchange
Rate Mechanism (ERM II) of the European Monetary
System (EMS) within the normal fluctuation margin without
severe tensions for at least two years and without having
requested a devaluation.
 useless or even counterproductive?
26
Accession Criteria - 1
Convergence criteria
Country
Reference value
(as of May 2007)
Target date
Government
finances
Recomm
ERM II
Obligati
ended Euro coins
Inflation Governm
Set by the
design
membership
Interest
rate
on
to
by the
Governm
rate
country
ent
since
adopt
Commiss
ent debt
deficit to
ion
to GDP
GDP
max
3.0%
max. 3%
max.
60%
min. ERM II
stay: 2 years
max 6.4%
NA
NA
NA
NA
Denmark
2.10%
-3.90%
30.0%
1-Jan-99
5.20% opt-out
not yet set
NA
none yet
Sweden
1.50%
-2.00%
50.9%
0 years
3.70%
not yet set
NA
none yet
United Kingdom
2.20%
4.00%
42.2%
0 years
5.00% opt-out
NA
NA
none yet
yes
Source: European Commission
27
Accession Criteria - 2
Convergence criteria
Government
finances
Country
Reference value
(as of May 2007)
Target date
ERM II
Obliga
Inflation Governm
Set by the
membership Interest rate tion to
Governm
rate
country
ent
since
adopt
ent debt
deficit to
to GDP
GDP
max
3.0%
max. 3%
max.
60%
min. ERM II
stay: 2 years
max 6.4%
Recommended
by the
Commission
Euro
coins
design
NA
NA
NA
NA
Bulgaria
4.60%
-3.10%
29.9%
0 years
3.80%
yes
2009-2010
NA
in progress
Cyprus
2.00%
1.50%
65.3%
2-May-05
4.20%
yes
1/1/2008
1/1/2008
ready
Czech Republic
2.20%
3.60%
30.4%
0 years
3.80%
yes
not yet set
NA
in progress
Denmark
2.10%
-3.90%
30.0%
1-Jan-99
5.20% opt-out not yet set
NA
not yet
Estonia
4.30%
-2.30%
4.5%
28-Jun-04
-4.10%
yes
2010
To be announced
ready
Hungary
3.50%
10.10%
61.7%
0 years
7.10%
yes
2010-2014
NA
in progress
Latvia
6.70%
-0.10%
12.1%
2-May-05
3.90%
yes
2010-2012 To be announced
Lithuania
2.70%
0.50%
19.7%
28-Jun-04
3.70%
yes
2010
To be announced
ready
Malta
2.20%
2.60%
66.5%
2-May-05
4.30%
yes
1/1/2008
1/1/2008
ready
Poland
2.30%
3.70%
47.0%
0 years
4.25%
yes
2012
NA
in progress
Romania
4.00%
2.50%
20.3%
0 years
8.00%
yes
2014
NA
none yet
Slovakia
4.30%
3.10%
34.5%
28-Nov-05
4.30%
yes
2009
To be announced
ready
Source: European Commission
ready
28
Accession Criteria - 3
Convergence criteria
Country
Reference value
(as of May 2007)
Government
finances
Recom
mende Euro
ERM II
Obligat Set by
coins
Inflation Governm
d by
membership Interest rate ion to
the
Governm
design
rate
the
ent
since
adopt country
ent debt
Commi
deficit to
to GDP
ssion
GDP
max
3.0%
Croatia
Target date
max. 3%
max.
60%
min. ERM II
stay: 2 years
max 6.4%
NA
NA
NA
NA
2.70%
2.20%
40.8%
0 years
NA
NA
NA
NA
3.20%
0.60%
39.5%
0 years
NA
NA
NA
NA
Turkey
9.50%
0.60%
60.7%
0 years
NA
NA
NA
NA
Albania
2.40%
0 years
NA
NA
NA
NA
0.90%
0 years
NA
NA
NA
NA
Serbia
0 years
NA
NA
NA
NA
Montenegro
0 years
NA
NA
NA
NA
Republic of
Macedonia
Bosnia and
Herzegovina
10%
Source: European Commission
Back
29
6. Economic Issues Regarding
The Adoption of the Euro -1

Fast or slow?
+ If net gains large and costs falling over
time  quick adoption
+ If benefits and costs balanced and
benefits rise over time  take your time
+ All subject to fulfillment of Maastricht
criteria!
30
6. Economic Issues Regarding
The Adoption of the Euro - 2

Some major issues:
+ (Prudent) Fiscal positions (e.g.: Hungary)
+ Inflation (-differentials)  BalassaSamuelson effects (e.g.: Estonia, Lithuania)
+ Capital flows (Sudden stops and reversals)
+ Financial sector development
31
6. Economic Issues Regarding
The Adoption of the Euro - 3


Vulnerabilities
+ Capital account volatility (policy inconsistency,
asymmetric shocks, exit date risks)
+ Credit booms
+ Economic booms
Possible strategies to minimize risks up to
the €
+ reduce fiscal deficits, contain inflationary
pressures and maintain growth (structural
adjustment)
32
6. Economic Issues Regarding
The Adoption of the Euro - 4

Entry into &Time spent in ERM II
New EMS can join ERM II any time after EU accession.
“training room” - or “waiting room” approaches

Strategies:
+ Adopt Euro as soon as possible and in ERM II as late as
necessary (i.e. > 2 years before
+ Participate in ERM II as soon as possble and then take
time to prepare for Euro adoption
+ „Wait and See“ approach

Risks of (untimely) ERM II entry:
+ Risk for too tight a corset
+ Risk for too loose a corset
+ Risk of speculative attacks
Back
33
7. The Adoption of the Euro:
The Case of Greece - 1

Greece: EU 1981, at the time an EME at best (low income,
high volatility, underdeveloped financial markets, etc.),
highly regulated, capital controls, quite closed economy,
political business cycles, structural rigidities.

Until mid-1990s inconsistent policies, fiscal dominance,
futile search for nominal anchors (independent monetary
policy an asset?), speculative attacks, currency crises,
current account driven balance of payments crises; wage
excesses, huge, persistent disequilibria, key economic
indicators 1981 – 1995:




average inflation rate ~ 20 % p.a.,
average budget deficit ~ 10% p.a.,
public debt from <20% to ~ 120% of GDP
average real growth ~1 % p.a.
34
7. The Adoption of the Euro:
The Case of Greece - 2

1995: Fundamental political decision to pursue policies
that will allow Greece to introduce the euro in 2001 
fundamental, sustained policy shift, anchored at
Maastricht:






stability-oriented monetary policy: (pre-announced) “hard
currency peg”),
fiscal consolidation,
tight prudential regulation and supervision of banks,
structural adjustment (privatization, wage bargaining
processes, deregulation, financial market liberalization).
1998: ERM entry AFTER policies set and intended euro
adoption date (2001) credible!
Strong political will, broad political support, and adequate
economic policies DECISIVE
35
7. The Adoption of the Euro:
The Case of Greece - 3




ERM entry (March 1998) with a
devaluation
Thereafter: significant Drachma
appreciation with some volatility; but very
smooth exchange rate development as of
spring 1999!
Credibility of maintaining adequate policies
Credibility of endpoint/exit! (+ conversion
rate)
36
7. The Adoption of the Euro:
The Case of Greece - 4
Svensson test for Greece
Greek 10y-Interest Rate Bands Implied by Broad EMS Bands
25%
20%
S
it  1  it*  
 St 
 
15%
10%
1
10
GDR 10y max
GDR 10y rate
2000M12
2000M7
2000M2
1999M9
1999M4
1998M11
1998M6
1998M1
1997M8
1997M3
1996M10
1996M5
1995M12
1995M7
1995M2
1994M9
1994M4
1993M11
0%
1993M6
5%
1993M1

GDR 10y min
Back
37
7. The Adoption of the Euro:
The Case of Greece - 5
GRD/Euro(ECU)
360.00
Revaluation
350.00
340.00
330.00
320.00
Introduction
of the Euro
ERM I-entry
310.00
GRD/Euro-Spot


01.01.2001
01.11.2000
01.09.2000
01.07.2000
01.05.2000
01.03.2000
01.01.2000
01.11.1999
01.09.1999
01.07.1999
01.05.1999
01.03.1999
01.01.1999
01.11.1998
01.09.1998
01.07.1998
01.05.1998
01.03.1998
01.01.1998
300.00
GRD-Central Rate
March 16, 1998: Central rate: ECU/EUR 1 = GRD 353.109
January 17, 2000: New CR = GRD 340. 75 = Conversion rate
Back
38
7. The Adoption of the Euro:
The Case of Greece - 6




What about (independent) use of monetary
policy in the run-up to the euro?
+ Recall Impossible Trinity: fixed exchange
rates and open capital account  no monetary
independence!
But, Greece:
Use of tight monetary policy to reach inflation
criterion until late 2000.
High real interest rates did cause significant
capital inflows; sterilizing interventions bought
time at the cost of come 0.5% of GDP.
39
The Impossible Trinity
Free Capital
Movements
Let exchange rate float
to maintain
monetary independence
Use monetary policy
to maintain
exchange rate peg
Pegged Exchange
Rate
Capital
controls
Independent
Monetary Policy
Back
40
7. The Adoption of the Euro:
The Case of Greece - 7
Three-Month Money Market-Spread
(GRD minus DEM)
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00
Jän.01
Nov.00
Sep.00
Jul.00
Mai.00
Mär.00
Jän.00
Nov.99
Sep.99
Jul.99
Mai.99
Mär.99
Jän.99
Nov.98
Sep.98
Jul.98
Mai.98
Mär.98
Jän.98
0.00
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41
7. The Adoption of the Euro:
The Case of Greece - 8



Conclusions on Greek experiences:
EMU provides the special circumstances
to make the middle to be stable.
Only enter ERM II once convergence
policies are CREDIBLY enacted and on
track.
Importance of credible exit date and
common view on conversion rate
Back
42
8. Experiences with EMU
-1Positive results
 How to deal with heterogeneity in EMU?
+ Growth divergence
 working of adjustment mechanisms
+ Inflation divergence
 matter for concern or a normal
phenomenon?
 endogeneity of OCA criteria (labor mobility,
fiscal transfers)

Back
43
8. Experiences with EMU: Growth convergence
-2-
Back
44
8. Experiences with EMU
-3-
Back
45
9. Some General Conclusions - 1



EMU is a unique experiment combining a
supranational monetary policy with still
national, albeit loosely coordinated, fiscal
policies.
EMU has a very important political
dimension.  Sets it aside from other
regions thinking about a MU.
Policy coordination in EMU and EU mostly is
about coordination among fiscal policies
and between fiscal and other economic
policies and NOT between fiscal and
monetary policies.
46
9. Some General Conclusions - 2



The Maastricht Treaty stipulates that in case of
inconsistencies between fiscal and monetary
policy the former has to yield to the latter: the
Maastricht framework is one of monetary
dominance as opposed to fiscal dominance.
The Treaty does not foresee ex ante coordination between fiscal and monetary
policies.
Greece offers some useful insights for EU
countries that as yet have not adopted the
Euro.
47
THE END
THANK YOU
FOR YOUR ATTENTION!
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