Theorie und Politik der Europäischen Integration

Theorie und Politik der Europäischen Integration • Theory and Politics of European Integration Lecture 7 The EURO and Optimal Currency Area Theory Fiscal Policy and the Stability Pact • Prof. Dr. Herbert Brücker

The last Lecture Theory and Politics of European Integration Fiscal Policy and Stability Pact • A Monetary History of Europe • The Gold Standard • Hume‘s Mechanism: Monetary Equilbrium under the Gold Standard • The Interwar Period • The Bretton Woods System • The Snake and the Super-Snake • The EURO • The Choice of an Exchange Rate System • The long-term neutrality of money in the AS-AD Diagram • Fiscal Policy in the IS-LM Diagram • Monetary Policy in the IS-LM Diagram • The trade-off between fiscal and monetary policies

This Lecture Theory and Politics of European Integration Fiscal Policy and Stability Pact Optimum Currency Area (OCA) Theory • What are the trade-offs? • Asymmetric shocks and currency areas • Criteria for an optimal currency area The European Monetary Union (EMU) • Maastricht Treaty and History • The Eurosystem • Objectives, instruments and strategy • The record during the first years

This Lecture Theory and Politics of European Integration Fiscal Policy and Stability Pact • Fiscal Policy and the Stability Pact • Fiscal policy in the monetary union • More and more important? • Borrowing instead of transfers • Automatic stabilizers and discretionary policy actions • Fiscal policy externalities • Spillovers and coordination • Cyclical income spillovers • Borrowing cost spillovers • Excessive deficit and the no-bailout clause • Collective discipline

Reading Theory and Politics of European Integration Fiscal Policy and Stability Pact • Richard Baldwin/Charles Wyplosz, The Economics of European Integration, 3rd Edition, 2009, Ch. 11 (Optimum Currency Areas) and Ch. 18 (Fiscal and Stability Pact)

Exam Theory and Politics of European Integration Fiscal Policy and Stability Pact • Topics • Microeconomics of Trade • Preferential Trade Liberalization • Scale Economies (BECOMP diagram) • Trade and Competition Policies • Dynamics of integration • Capital and labour mobility • Macroeconomics of monetary integration • Optimum Currency Area Theory • European Monetary Union and Eurocrisis (next lecture)

A good question, no simple answer Should curreny area borders coincide with national borders? If not, how best to delineate currency areas? What economic criteria should be used? Theory and Politics of European Integration Optimal Currency Areas

The economic toolkit There must be benefits and costs involved in adopting a common currency The solution has to involve trading off these benefits Theory and Politics of European Integration Optimal Currency Areas

In a nutshell The benefits Money exhibitsincreasingreturns to scale(network externalities) E.g. yousave transaction costs for money exchange the people use yourcurrency The world is the way to maximizethesebenefits The costs Loss of monetary and exchange rate instruments Matters in presence of: Price and wagestickiness Asymmetricshocks Theory and Politics of European Integration Optimal Currency Areas

Focusing on costs Start with the idea that benefits argue for one worldwide currency Ask why not Look at the costs No precise way of estimating costs and benefits so, in the end, a matter of judgement Look at asymmetric costs How they create trouble What makes them more likely What makes them less painful Theory and Politics of European Integration Optimal Currency Areas

Asymmetric shocks Simplestexample: an adverse demandshock: how can the exchange rate help? Assumption: stickyprices and wages Definition of exchange rate: EP/P* or in terms of wages: E W/W* Theory and Politics of European Integration Optimal Currency Areas

Asymmetric shocks Simplest example: an adverse demand shock: how can the exchange rate help? Theory and Politics of European Integration Optimal Currency Areas • If domestic prices and wages are sticky, adverse demand shock will reduce production to C if exchange rate does not adjust

Asymmetric shocks Simplest example: an adverse demand shock: how can the exchange rate help? Theory and Politics of European Integration Optimal Currency Areas • If exchange rate adjusts, production declines to D.

Asymmetric shocks: adverse demand shock in 2 country CU Theory and Politics of European Integration Optimal Currency Areas

Asymmetric shocks: adverse demand shock in 2 country CU Theory and Politics of European Integration Optimal Currency Areas No currency union case:Real exchange rate declines in country A to λ1, productiondeclinesto B, country B remainsunaffected. Whatwould happen ifexchange rate staysatλ0?

Asymmetric shocks: adverse demand shock in 2 country CU Theory and Politics of European Integration Optimal Currency Areas Currency union case:Central Bank let currency decline to λ2. productiondeclines in country A to C, in country B to D, andexcessdemandcreatesinflationarypressure D-D‘.

Asymmetric shocks: adverse demand shock in 2 country CU Theory and Politics of European Integration Optimal Currency Areas • Disequilbria don‘t last forever. In country A wages and prices decline, such that production moves to equilibrium point B. In country B wages and prices will increase, until economy is back to point A as well.

Implications of asymmetric shocks Thus, both countries are hurt when they share the same currency Also the case when a symmetric shock creates asymmetric effects This is an unavoidable cost of a currency area Theory and Politics of European Integration Optimal Currency Areas

Six critieria for a optimal currency area Next questions: What reduces the incidence of asymmetric shocks? What makes it easier to cope with shocks when they occur The analysis develops six criteria for an optimal currency area (OCA) Three economic labour mobility diversion trade openness Three political transfers homogeneous preferences Common destiny Theory and Politics of European Integration Optimal Currency Areas

Criterion 1 (Mundell): Labour mobility In an OCA labour moves easily across national borders. Caveats Labour mobility is easy within national borders (culture, language, legislation, welfare, etc…), but much less so across national borders Capital mobility: difference between financial and physical capital In case of country specialization, skills also matter and hinder labour mobility Theory and Politics of European Integration Optimal Currency Areas

Asymmetric shocks: adverse demand shock in 2 country CU Theory and Politics of European Integration Optimal Currency Areas • What happens with labour mobility? • Assume exchange rate declines to λ2 and production is at B in country 1 and D in country 2.

Asymmetric shocks: adverse demand shock in 2 country CU • Labour mobility shifts supply curve leftwards in country 1 to S‘ and rightswards in country 2 to S‘. • New equilbrium ar C and D‘. • Output gap is zero. Theory and Politics of European Integration Optimal Currency Areas

Criterion 2 (Kenen): Production diversification Countries whose production and exports are widely diversified and of similar structure form an OCA. Indeed, in that case, there are few asymmetric shocks and each of them is likely to be of small concern Theory and Politics of European Integration Optimal Currency Areas

Criterion 3 (McKinnon): Openness Countries which are very open to trade and trade heavily with each other form an OCA. Distinguish between traded and non-traded goods Traded good prices are set worldwide A small economy is price-taker, so the exchange rate does not affect competitiveness In the limit, if all goods are traded, domestic good prices must be flexible and the exchange rate does not matter for competitiveness Theory and Politics of European Integration Optimal Currency Areas

Criterion 4: Fiscal transfers Countries that agree to compensate each other for adverse shock form an OCA. Transfers can act as an insurance that mitigates the costs of an asymmetric shock Transfers exist within national borders Implicitly through the welfare system (e.g. unemployment benefits) Explicitly in federal states Theory and Politics of European Integration Optimal Currency Areas

Criterion 5: Homogeneous preferences Countries that share a wide consensus on the way to deal with shocks form an OCA. Matters primarily for symmetric shocks Prevalent when the Kenen criterion is satisfied Do countries agree how to adress symmetric shocks? Should we favour exporters (currency depreciation) or consumers (currency appreciation)? How much? May also help for asymmetric shocks Better understanding of partners’ actions Encourages transfers Theory and Politics of European Integration Optimal Currency Areas

Criterion 6: Commonality of destiny Countries that view themselves as sharing a common destiny better accept the costs of operating an OCA. A common currency will always face occasional asymmetric shocks that result in temporary conflicts of interests This calls for accepting such economic costs in the name of a higher purpose Solidarity vs. Nationalism Theory and Politics of European Integration Optimal Currency Areas

Is Europe an OCA? A synthetic OCA index: How much of a currency appreciation/devaluation vis-à-vis the DM is needed to keep economic conditions unchanged? A ten year period is considered. Indicator for the relevance of adjustment pressures from asymmetric shocks. Theory and Politics of European Integration Optimal Currency Areas

Is Europe an OCA? Asymmetric effects of symmetric shocks: effects on GDP and prices of a change of the common interest rate (increasing the interest rate by 1 per cent) Theory and Politics of European Integration Optimal Currency Areas

Inside the OCA index: Openness Most EU countries are very open: The McKinnon criterion is broadly satisfied Theory and Politics of European Integration Optimal Currency Areas

Inside the OCA index: Diversification Most EU countries have a diversified production structure (intra-industry trade dominates) The Kenen criterion is broadly satisfied and well explains which countries joined the euro area Theory and Politics of European Integration Optimal Currency Areas

Inside the OCA index: Labour mobility (1) The labour mobility criterion cannot be black-and-white The migration response to economic incentives must consider many costs: Moving costs Risk of becoming unemployed Longer run career opportunities Family prospects Eligibility to welfare Taxation Cultural/linguistic differences National attachment Theory and Politics of European Integration Optimal Currency Areas

Inside the OCA index: Labour mobility (2) An international comparison suggests that labour mobility is low in Europe Across countries Even within countries Theory and Politics of European Integration Optimal Currency Areas

Inside the OCA index: Labour mobility (3) Low labour mobility implies that unemployment bears much of the burden of adjustment to shocks An US-EU comparison: How much of an initial employment shock is absorbed by labour mobility? Theory and Politics of European Integration Optimal Currency Areas

Inside the OCA index: Transfers The EU does not satisfy the transfercriterion The overall EU budget islow, cappedat 1.27% of EU GDP entirelyused for administration, CAP, regional and structural funds Thesefunds do not varywith the business cycle and are not earmarked to addressasymmetricshocks This changes with the ESM/ESRM facilities in the course of the Eurocrisis Theory and Politics of European Integration Optimal Currency Areas

Inside the OCA index: Homogeneity of preferences Preferences could affect the role of monetary and fiscal policies to address external shocks Littleis known about this criterion Eurbaometer survey suggest that people agree on common decisionmaking for defence (64%), but 67% reject decisionmaking in the area of social affairs Eurocrisis show increasing tensions across nations and their populations and disagreement e.g. on fiscal transfers and macroeconomic policies Theory and Politics of European Integration Optimal Currency Areas

Inside the OCA index: Commonality of destiny Little is known about this criterion Public opinion polls do not reveal deep opposition to EU institutions Theory and Politics of European Integration Optimal Currency Areas

Summarizing Theory and Politics of European Integration Optimal Currency Areas

Overall Is the OCA glass half full or half empty? Theory and Politics of European Integration Optimal Currency Areas

History never ends: the endogeneity of OCA criteria Living in a monetary union may help fulfill the OCA criteria over time Would the US be an OCA without a single common currency? Will the existence of the EURO area change matters too ? Will the Eurocrisis create further integration e.g. via fiscal transfers and common fiscal policies or further disintegration? Split between the South and the North? Will no-Eurozone members leave EU, e.g. UK? Theory and Politics of European Integration Optimal Currency Areas

Will trade deepen? Little evidence that reducing exchange rate volatiliy increases trade Mounting evidence that eliminating exchange rate volatility by adopting a common currency raises trade a lot Estimates range from 50% to 100% The “border effect”provides similar estimates Theory and Politics of European Integration Optimal Currency Areas

Will diversification grow or decline? Argument 1: intra-industry trade will grow Argument 2: specialization will increase No firm conclusion so far Theory and Politics of European Integration Optimal Currency Areas

EMU and labour markets Mobilitymay not change much, but wagescouldbecomelesssticky Twoviews: The virtuouscircle: labour marketsrespond to enhancedcompetition by becoming more flexible The hardeningview: labour marketsrespond to enhancedcompetition by increasing protective measuresthatraisestickiness The jury isstill out: EURO crisis has not muchincreased labour mobility in 2010, but in 1st halfyear of 2012 E.g. Greek migration in Germany: + 80%. But: Substantial diversion of migration flowsfrom NMS equilbriate labour supplybetweencrisis and non-crisis countries Theory and Politics of European Integration Optimal Currency Areas

Are the other criteria endogenous? Transfers No support for more taxes fo finance transfers at beginning of EMU But: Meanwhile 50% of German population support at least some transfers to bailout Greece Homogeneity of preferences No presumption that it will change soon, but EURO crisis my force countries to do so (e.g. zero debt ceiling) Commonality of destiny No presumption that it will change soon Theory and Politics of European Integration Optimal Currency Areas

In the end Monetary union is not only about economics The OCA criteria do not send a clear signal The EU is not a perfect OCA A monetary union may function, at cost The OCA criteria tell us only partly where the costs will arise: Labour markets and unemployment Political tensions in presence of deep asymmetric shocks Fiscal shocks and imbalances like real estate bubble remain largely unadressed Theory and Politics of European Integration Optimal Currency Areas

Fiscal Policy and the Stability Pact Theory and Politics of European Integration Fiscal Policy and Stability Pact • Fiscal Policy and the Stability Pact • Fiscal policy in the monetary union • More and more important? • Borrowing instead of transfers • Automatic stabilizers and discretionary policy actions • Fiscal policy externalities • Spillovers and coordination • Cyclical income spillovers • Borrowing cost spillovers • Excessive deficit and the no-bailout clause • Collective discipline

The fiscal policy instrument Theory and Politics of European Integration Fiscal Policy and Stability Pact • In a monetary union, the fiscal instrument assumes greater importance • The only macroeconomic policy instrument left at the national level • Its effectiveness is increased (a result from the Mundell-Fleming model) • Heavily used in 2008 financial crisis and subsequent period • A subsitute to transfers • Yet, many questions arise regarding its effectiveness and use

Limits on effectiveness Theory and Politics of European Integration Fiscal Policy and Stability Pact • The crucial role of private expectations • A deficit today but a debt tomorrow: who will pay? • A tax cut, but how permanent? • Slow implementation • Agreement within government • Agreement within parliament • Spending carried out by bureaucracy • Taxes not retroactive • Result: countercyclical moves can become procyclical actions and in extreme cases create fiscal crisis (default of government bonds)

A crucial distinction: automatic vs. discretionary Theory and Politics of European Integration Fiscal Policy and Stability Pact • Automatic stabilizers • Tax receipts decline when the economy slows down, and conversely • Welfare spending rise when the economy slows down, and conversely • No decision, so no lag: nicely countercyclical • Rule of thumb: deficit worsen by 0.5% of GDP when GDP growth declines by 1%

Theorie und Politik der Europäischen Integration