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Chapter 11:
The Euro and Financial Markets
De Grauwe:
Economics of Monetary Union
The Euro intensifies
financial integration
•
•
•
•
The money markets
The bond market
The equity markets
The banking sector
Important obstacles remain
• The bond market
• The equity markets
• The banking sector
Banking sector is least integrated, and
remains segmented despite Euro
Reason: national regulators and supervisors
have no incentive to open up banking
sector
As long as deep differences in legal systems
remain in place financial integration will be
incomplete
Why financial integration is important
• Financial integration is a substitute for fiscal
integration
• It provides for risk sharing
• In US this is twice as important than risk
sharing through the government budget
Aggregate demand and supply with
asymmetric shocks
PF
France
PG
Germany
SG
SF
DF
DG
YF
YG
• Empirical evidence shows that the insurance
system in the Eurozone is poorly organised at
this moment
• The only risk sharing mechanisms that are in
place involve redistributions between different
generations within the same countries
Conditions for Euro to become
world currency like dollar
•
•
•
•
Size: real and financial
Degree of integration and deregulation
Price stability
Macroeconomic stability
Eurozone’s real economy
at least as big as US
Share of output and trade in world totals
35
30
percent
25
20
output
15
trade
10
5
0
EU
US
Japan
Size of equity and bond markets
Outsta nding e quity a nd bonds
14000
b illio n d ollars
12000
10000
8000
equity
6000
bonds
4000
2000
0
EU
US
Japan
The policy environment
• A currency can only graduate to an
international role if there exists monetary and
financial stability at home
• The foremost indicator of monetary stability is
the rate of inflation (which measures the
stability of the purchasing power of money)
• In both Europe and the USA, price stability
has become the major objective of policymaking
• Financial stability matters
• Japan was even more successful in
maintaining price stability than Europe and
the USA during the 1990s and the early
2000s
• Yet a financial crisis erupted that has led to a
serious setback for the yen as an
international currency
• Financial stability conditions have to do with
government debts and deficits, and the
stability of the financial system
Inflation in the Euro area,
USA, and Japan
6
United States
Japan
Euro area
5
4
per cent
3
2
1
0
-1
-2
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Government debt in the
Euro area and USA (% of GDP)
80
75
70
per cent
65
60
55
Euro area
United States
50
45
40
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Conclusion
• The Euro has the potential to become an
international currency
• It will take some time to match the dollar
– Differences in size
– Insufficient integration
Note: factors that affect potential for a currency
to become a global one are not directly
related to factors that affect strength of a
currency
Jan-99
Apr-99
Jul-99
Oct-99
Jan-00
Apr-00
Jul-00
Oct-00
Jan-01
Apr-01
Jul-01
Oct-01
Jan-02
Apr-02
Jul-02
Oct-02
Jan-03
Apr-03
Jul-03
Oct-03
Jan-04
Apr-04
Jul-04
Oct-04
Jan-05
Apr-05
Jul-05
Oct-05
Jan-06
Apr-06
Jul-06
Oct-06
Jan-07
US dollar/Euro
Euro–dollar exchange rate
(1999–2006)
1,40
1,30
1,20
1,10
1,00
0,90
0,80