5. Monetary union : costs , benefits , unresolved issues

1. 5. Monetaryunion: costs, benefits, unresolvedissues 5.1 Costs of a monetaryunion (macroeconomic) 5.2 Benefits of a monetaryunion (microeconomic) 5.3 Fiscalpolicy and sustainability of publicfinances 5.4 Bankingand financialstability 5.5 The balance of costs and benefits

2. 5.1 Macroeconomiccosts • A memberstate of a monetaryunionlosesitsability to pursue an independentmonetarypolicyas well as the automaticadjustment of the exchangerate. As demonstratedabove and as is the point of the OCA-literature (optimumcurrencyarea), thismaybeharmfulif the country is hitbydemandshocks, notablyiftheseareasymmetric (differs as beteencountries, implyingthat ”onesizefitsall” monetarypolicycannotindeedfitall). • Thispresumesthatindependence of monetarypolicy is useful in counteringcertainshocks and thatmonetarypolicy is implementedwisely (and thatexchangeratefluctuationsarenotexcessivelyerratic, as exchangeratespredominantlydeterminedby capital flowmaybeproblematic). • Itmakes a differenceif the shocksaretemporaryratherthanpermanent: temporaryshocksdonotnecessarilycall for adjustment, theycanbedealt with byfiscalstabilizersorfiscalpolicy. • Also, the supply side and wagebehaviourmatter for the rolethatpolicies and exchangerateregimescan play: flexiblewagesmakeadjustmentpossibleevenwithoutexchangerateflexibility, and the latterdoesnot help ifthere is realwagerigidity. • Asymmetricshockscanarisealsobecause of structuraldifferences as betweenmembers of the monetaryunionand/orbecause of differences in fiscalorotherpoliciespursued

3. Asymmetricdemandshock: inflation Assume a monetaryunion of twocountries, A and B, bothSOEs in a largerworld. Assume international demand to shiftfrom output of country B to output of country A. The exchangerate is sofarassumed to be unchanged. Initialequilibrium is at point A, the intersection of the aggregatedemand and aggregatesupplycurve. The P ASLR aggregateddemand for output of country A shifts AD’ from AD to AD’. Wages and pricesmaybesticky in the AD D shortrun, thus a new SR-equilibrium is at point B. ASMR However, abovenormalemploymenttriggers C inflation, and a new medium-termequilibriummay A B ASSR be at point C. If the long runsupplycurve is vertical, the new LR-equilibrium is at D, where the domestic wage and pricelevel is higherbutemployment unchanged. Y NB that the effects of the shockmighthavebeenmitigatedby an exchangerateappreciation of A (shifting the AD-curveleftwards).

4. Asymmetricdemandshock: deflation Assumethat country B is correspondinglyhitby a negativedemandshock. Monetarypolicy and the exchangerateareassumedunchangedbecause the overalllevel of demand in the monetaryunionhasnotchanged. P AD ASLR AD’ ASMR B A ASSR C Y Initialequilibrium is at point A. Thenoveralldemandshiftsfrom AD to AD’. SR-equilibriummaybe at point B, MR-position at C, and LR-equilibrium at point D (if the LR supplycurve is vertical). Thus, output and employmentwouldbeunchangedbut the wage and pricelevelwouldbelower. However, whatifwagesdonotdecline, ordosoveryslowly? The theeconomymaybestuck in a lowemployment trap for an extendedtimeperiod. Whatif the CB of the MU raisesinterestrates to steminflationarypressurearising in country A? Thiswouldfurtherworsen the situation in country B as the currencywouldappreciate. Life wouldbeeasier with a depreciation in B?

5. Asymmetricshocks: furtherpoints Assumethatonlyone country oronepart of the monetaryunion is hitby a negativedemandshock. This country willsufferfromlowergrowth and higherunemployment, and conceivably the situationwill in duetimecorrectitselfthrough a domesticconstadjustment. Butwhat is happening to the rest of the monetaryunion? • Theremaybesomedirectnegativespillovers to othercountriesthroughweakerdemand for theirexports • Assumingweakerinflationpressure in the problem country, the ECB maylower the interestrate a bit, whichmightalsoweaken the exchangerate of the monetaryunion: botheffectswouldalleviate the recession in the weak country and supportgrowth in the rest of the union Assumeinstead the converse: thatone country is booming, while the rest of the union is notdirectlyaffected. This country willthenexperiencehighergrowth and inflationarypressure. For the othercountries: • Therewillbesomepositivecross-borderdemandeffects • This is allif the ECB keeps the interestrateconstant. However, if the ECB raisesinterestrates to steminflationarypressure, thismayhurtgrowth in the othercountries of the union. Point: Asymmetricshocksarelikely to pose a problem for a monetaryunion.

6. 5.2 Benefits of a monetaryunion • The elimination of transactioncostsfor tradewithin the area of the monetaryunion. Elimination of transactioncosts is convenient for households (thoughmostpaymentsareanywaydonebycreditcards) whentravelling and for business, notably for small and medium-sizedcompanies (SMEs) • The size of thisgainhasbeenassessed to besomefraction of a per cent of GDP (maybe a quarterorhalf of a percent of area-side GDP) • There is a nowadays a regulationforcingbanks to apply the samecharges on euro-areacross-borderpayments, and ATM-withdrawals (and smallcredittransfers) as thoseapplied for domesticpayments. Thishascontributed to what is now a ratherfullyintegratedpaymentssystem in the euro area. • The single currencyreducessignificantlyexchangerateriskswithin the union (thoughsomedegree of ”convertibilityrisk” mayremain) • A counterargument is thatelinination of exchangerateriskmay show up as increasedmacroeconomicriskbecause of the lack of the depreciation option • Membership in a monetaryunionmayalsoincrease the defaultrisk as there is no domesticcentralbankwilling to buygovernmentpaper in case of fundingdifficulties for the government

7. (cont.) • The reducedtransactioncosts and exchangeraterisksmayimprovepricetransparency and therebycross-bordercompetition, whichshouldenhance the efficiency of the allocation of resources and productivitygrowth • There is someevidencethat the euro hasstimulatedtrade, particularly of SMEs, and cross-borderinvestmentwithin the area, but the effectsseem to bemodest (5% - 20 %). • Elimination of exchangeraterisk (within the area) couldhave the effect of lowering the interestratethrough a lowerriskpremium. Thiswouldspureconomicgrowth in the medium term and lead to a higher capital ratio • However, there is littleevidencethat the euro in itselfwouldhavelowered the interestrateorhadanymajorconsequences for growth • Therecouldbeadditionaladvantagesif the euro were to become an important international currency, used as the currency in tradecontracts, therebyreducing the externalexchangeraterisk for euro-areaproducers • Also, the euro areawouldreapseignoragebenefitsorbenfitfromlowinterestratestifeuro-denominatedassetswerewidelyheldbyforeigncentralbanks

8. 5. 3 Sustainability of publicfinances Therearereasons for which the cumulativeeffect of governmentbudgetdeficitsmaycumulateso as to create a situationwhich is unsustainable: the governmentrisksdefaulting on itsoutstandingcommitmens (itsdebt). Conceivablereasons for such a situation to emergeinclude • A deficitbiasin publicfinances: decisionmakersprefer (becuase of myopia, or the influence of lobbyistorsheerpoliticalopportunism) spendingand/ortaxreductionsnow at the expense of incurringdebt, whichbecomes a burden on youngor new generations • The country maysufferfrom a deep and long recession, whichreducestaxrevenues and increasesspending for the unemployed • The country mayface the consequences of demographicchange, in the form of agingpopulations, whichincreaseage-relatedpublicspending • The country maybehitby a bankingcrisis, whichforces the government to bail out largeparts of the bankingsystem • Historically the most common reason for publicsectorfinancingdifficultieshavebeen the consequences of war, butalsobankingcriseshaveoften led to largeincreases in publicdebt

9. (cont.) The change in the level of indebtednessor the ratio of governmentdebt to GDP, v = D/Y , canbewritten as = /Y) - (D/Y)(/Y) Assumingthat the change in debt is equal to the budgetdeficit (leavingasidevaluationaspects) = G – T + rD This allows the change in the debt ratio over time to be written as = (G – T + rD)/Y - vy = g – t + (r-y)v Where g =G/Y is government spending (excluding interest payments on government debt) to GDP, t = T/Y is the gross tax ratio, v = D/Y is the debt ratio, y = /Y is the rate of growth of GDP in nominalterms and r is the (nominal) rate of interest on governmentdebt. The difference g - t is oftenreferred to as the deficit on the ”primary” balance (i.e, the deficitexcludinginterestpayments).

10. (cont.) The governmentmayfaceborrowingdifficultiesif the assessment of the market is that the presentvalue of futuretaxrevenues is notenough to finance futurespendings, includingspending to service and repayoutstandingloans. The aboveequationhelps to see the ways in which the governmentmayhope to ameliorate the situation : • Itmayimprove the primarybalancebycutting (non-interest) expenditureorbyraisingtaxes • Itmaytry to achievestrongergrowth • Itcangeneratehigherinflation, whichwouldincreasenominal GDP growth, and hopethatthiswouldnotbereflected in a highernominalrate of interest • Itcantry to reduce the level of indebtednessbysellingproperty(privatization) orbynegotiating a voluntorywrite-down of debtwith creditors NB: governmentdebtfeedsitself (unless the rate of interest is lowerthan the rate of growth of the economy), whichmeansthat the process is unstableunlessstabilizedbypolicies operating on the primarybalance.

11. The prospect of default The upward-slopingcurveshows (r - y) v that the interestburden (rv), net of the t - g (r - y)vgrowtheffect, yv, is a positive and non-linearfunction of the debt to GDP ratio. This is because a highdebt B t - g raises the riskpremium in the interestrate. The othercurve assumesthat the authoritiestake action to improve the primary balancewhen the debtlevelrises. Point A is a stableequilibrium to which the economyconvergesover A time. However, anydebtlevel to the right of point B wouldbetoohigh to besustainable. (Itcouldarise, e.g. as a consequence of a bankingcrisis..) Also, 0 a downwardshift of the reactioncurve (to the dottedcurve) wouldlead to a unsustainableprocess as the debtwouldall the timegrowtoofast. Alternatively, the samesituationcouldariseif the (r-y)vcurveshiftsupwards. v

12. Multipleequilibria Expectations on financialmarketscansometimesbecomeself-fulfilling, meaningthattherecanbe ”good” and ”bad” equilibria, and thatpoliciescanhave an importanteffectbyaffectingthoseexpecations of investors. To seethis for the case of the market for governmentbonds, notefirstthat the interestrate on long-termgovernmentbondsvariesinversely with the price of the bond: for a given and fixedcouponrate, the effectiveyield on the bond is lower the higher the price to bepaid for the bond. At a givenmomentthere is a givenstock of outstandinggovernmentbonds. The demand for thosebonds, the willingness to holdthem in the portfolios of investors, willdepend on the rate of interest (oryield) earnedby holding suchbonds. Also, the demandwilldepend on expectationsconcerninghow the bondpricemightevolveovertime as well as the risk for default and the degree of risk aversion of the bondholders. The figurebelowshows the outstandingstock of bonds (verticalline) as well as the demand for bonds as a function of the price of the bond. At a highprice of the bond (lowinterestrate ), the demandcurve is downwardsloping and the intersection with supply (at point A) is a locallystableequilibrium (if the price is slightlylower, thenmoredemand to hold the bondswillbeforthcoming, whichwillraisetheirprice i.e. reduce the interestrate). At a substantiallylowerprice of the bond (higherinterestrate), a furtherpricereductionmayreducedemandbyincreasing the fear of default; the intersection with the supplycurve at point B thereforeamounts to a locallyunstableequilibrium. At stilllowerprices of the bonds, theremayemerge a class of speculativebuyerswilling to betthat the debtwill in the endberepaidand/orthat the interestwilldecline (price of bondwillrise). The temptation to buy the bondmaythenbebigger the lower the price of it (the higher the interestrate), and thus the demandcurvemayagainbedownward-sloping. The intersection at point C againrepresents a stableequilibrium. The governmentbyitspoliciesand/or the CB throughinterventionsmayaffectexpectations and thereby the equilibrium.

13. Multipleequilibria (cont.) The verticalline is the outstandingstock of governmentbonds. The (inversely) S-shapedcurve is thedemandcurve (cf. above). Points A and C representlocallystable (partial) equilibria, whilepoint B is a locallyunstableequilibrium. Governmentsoftentry to talk the interestratedown with the hope of getting to the ”good” situation. Ortheymaytakepolicyactions with thatpurpose. The CB caninfluence the outcomebyits interventions in the bondmarket and its commitments. price A B C amount At point A demand is a decliningfunction of price, because at a higherpriceitwillcostmore to acquireownership of a certainfuturestream of couponpayments (locallystableequilibrium). At a lowerbondprice (higherinterestrate) a stilllowerprice (a stillhigherinterestrate) mayraise the defaultrisk, therebyreducing the demand for bonds (aroundpoint B, locallyunstable). At a sufficientlylowprice (aroundpoint C) theremaybesomegroup of speculativeinvestorswilling to buy in the expectation of the possibility of bailout (locallystableequilibrium). Of course, the graph is onlyillustrative of the possibility of multipleequilibria. NB: Point A is here the ”good” equilibrium with a lowinterestrate.

14. 5.4 Banking and financialstability: the problem of highleverage Assumethat the economyhasbeendevelopingfavourably for a number of years, thatconfidence is high and riskpremia and interestratesarelow. The balancesheet of the representativeinvestor is A = K + L, A = totalassets, K = equity, L = debt The return on equity of the portfolio is rE= (rAA - rLL)/K = (rA(K + L) - rLL)/K = rA + (rA – rL)(L/K), where rE is the return on equity, rA the return on total assets, rL the rate on interest on debt and L/K the degree of leverage. Obviously, with optimistic expectations w.r.t. the return on investment and/or a low rate of interest on debt, the expected return on equity can be improved by increasing leverage. However, this is at the expense of higher risk or a higher variance of the rate of return: V(rE) = (1 + (L/K))2 V(rA) with V denoting variance (assuming no uncertainty for the interest rate. Obviously, the risk or variance of the return is an increasing function of the degree of leverage.

15. Banking and financialstability: spillovers The (highly) simplifiedbalancesheet of a representativebankcanbewritten as L + B = D + R + K where L is the stock of outstandingloans, B denotesotherinvestmentsby the bank (in, e.g., bonds), D stands for deposits (orfundsraise in the money market), R is debt to the centralbank (negativeif the bankholdspositivereserves in the CB), and K is equity capital. The banktypivallyhas a veryhighdegree of leverage and itmayendup in difficultiesif, e.g., - it is hitbycreditlosses on outstandingloans as a consequence of, say, havingfinancedrealestate speculationassociated with a housingpricebubble (and with highleveragealso for borrowers) - it is hitby capital losses on itsholdings of otherassetssuch as domesticorforeigngovernmentbonds (as a consequence of risinginterestrates and thereforelowervaluations of the bondsheld) - it is hitbydepositflight, as depositsaretypically of shortmaturity as compared to banklending (banksare in the business of ”maturitytransformation”). The last is a liquidityproblem and cannormallyberesolvedbyborrowingfrom the CB. However, the firsttwoproblemsconcernsolvency, theymaybringequity to a dangerouslylowlevelormakeitnegative. Of course, bankregulation and supervision try to ensurethatbanksdonotlendrecklessy, thattheyholdenoughequityrelative to risksincurred (capital ratios) and thattheydonotusedeposits to finance speculativeholdings of riskyassets. Problems of banksmayhave ”contagion” effects on otherbanks, and theremaybeinteractions of sovereign (governmentdebt) and bankproblems.

16. Banking and financialstability: spillovers (cont.) Country 1Country 2 Bank problemsspillover to the government because the soverignmaynotwant to allow the bank to fail and is itsultimatesource of security, oftenwilling to bail out banks in trouble. Governmentproblemsspillover to banks becausefundingproblems of the government weaken the implicitguarantee of the banks, and becauserisinginterestrates (lowerprices) of governmentbondsmayinflict capital losses on banks. Governmentproblemsmayalsospillover to banks in othercountriesiftheyholdbondsissuedbyproblem countries in theirportfolios. Finally, in an integratedbankingsystembanksholdclaims on banksnotonly in their home country butalso on banks in othercountires: morespilloverpotential. Government Government Banks Banks

17. 5.5 The balance of costs and benefits Costs and benefits of a MU are a function, inter alia, of the degree of openness of the econmy Benefits Costs and Benefits, % of GDP MU notgood MU is OK Costs Degree of openness of the economy The benefits of savings on transactioncosts and reducedexchangerateuncertaintyarebigger the more open the economy. Also, the cost of adjusting to macroeconomicimbalancesaresmaller the more open the economy (variations in domesticdemandaffectimportsrelativelystrongly).

18. Costs and benefits of MU: furtherconsiderations Comparing a MU with a regime in whichcountriesretainmonetaryautonomy and a floatingexchangerate: • Asymmetricshocksare a source of problems in the MU (seeabove) • A MU functionsbetterifthere is wage and priceflexibilityand labour mobilitywithin the MU • On the otherhand, lack of wageflexibility, notably of ”realwage” flexibility is a problemirrespective of the exchangerateregime: realwageresistence (downwards) maypreventadjustment in a MU butmaygiverise to inflation (orstagflation) with floatingexchangerates (improvement of competitivenessrequireslowerrealwages) • Money marketor capital flowfluctuationsaremore of a problemunderfloatingexchangerates as compared to a MU, cangiverise to useless/harmfulexchangerateinstability • A highdegree of heterogeneity of the membership of the membership of the MU is a problem (byincreasing the risk for asymmetricsituaitons); also, MU is easier to live with ifyouhave a widelydiversifiedeconomy • Loss of monetaryautonomy is no big issueifmonetarypolicy is inefficentor the CB incompetent; membership in a MU maygivebettercredibilityfor lowinflationpolicies (for somecountries) • NB that the USA is notonly a MU butalso a fiscalunion (automaticredistributions at the federallevel) and a bankingunion • The MU willobviouslyfunctionbetterifallmembersrespect the rules of the regime(and pursue ”responsible” policies)

19. Settingup EMU: wasit a good idea (ex anteor a priori)? • ”Too early to tell” (ZhouEnlai’sresponse to the question ”whatdoyouthinkabout the frenchrevolution?”) • There is no counterfactual: wecannotknowwhatwouldhavehappenedif the EMU hadnotbeeninitiated (cannotmakecontrolledexperiments) • Therearegoodarguments for a monetaryunionamongsimilar and stability-orientedcountries: a monetaryunionbuiltaround the D-mark and the ”hardcore” (Germany, France and the Benelux countries) wouldprobablyhaveworkedwitoutproblems • Itwasprobablypositivelyharmful for somecountries to join the EMU: the EMU becamequiteheterogenous and the crisiscountrieswouldhavebeenunlikely to endup in as big a messiftheywouldhavestayed outside of EMU • In the case of Finland it is moredifficult to sayifmembershiphashadanysignificanteconomicconsequences (seelater) • The EMU wasconceived of as a ”rulesbased” system, whereonly the ECB wouldtakediscreationarydecisions; however, the crisis of recentyearshaverequired a number of politicaldecisions, for whichtherehasnotreallybeen an effectivedecision-makingmachinery • The EMU coming out of the currentcrisis (assumingitsurvives) will in manyways look differentfrom the EMU as set out in the Maastrichtreaty

20. Questions • What is the main cost of a MU? • Underwhichconditionswill the cost of a MU besmall (overallor for a particularmemberstate) • Whatare the main benefits of a common currency? • Whyorwhen is there an inherenttendencytowardsinstability of publicfinances? • What is the meaning of multipleequilibria in governmentbondmarkets? • Whatare the conceivableconsequences of highleverage of banks