Economics and Business Exchange Supported by Deloitte.

1. Economics and Business ExchangeSupported by Deloitte.

2. Monetary Union in EuropeRay Barrell

3. Outline and Plan • Why do we have a Monetary Union in Europe • The origins of the project and the idea • The political and economic steps to union • Why was EMU designed like this • What is the role of the ECB • Why do we have a Fiscal Pact • Has EMU been a success • What has happened to inflation • Why has output growth been slow • What will happen when new members join • Does it matter that the UK is outside

4. The monetary union project • Plans and discussion for monetary union started in the late 1960s and early 1970’s • Early plans were disturbed by events in the early 1970s and were delayed • Inflation rates in Europe diverged • The Exchange Rate Mechanism was set up in 1978 to create a converging path to monetary union • The Maastricht Treaty in 1990 was designed to set up the conditions

5. The political economy of union • EMU has been at least as much a political process as an economic one • Germany was the most successful economy in post war Europe • Austria and the Netherlands were in effective monetary union with Germany from 1983 • Political pressures fro union came as strongly from Netherlands and Belgium as France • There was a desire for a tight EMU • Others saw EMU as a way of dealing with their own political failings, and Italy and Spain saw it as a tool to induce structural change

6. Three Dimensions for Policy • Ensure high levels of output and sustainable trajectories for growth • Low and stable inflation • High inflation may be related to unstable inflation and is often unexpected • Contracts are hard to design in a world of unexpected inflation variability • Limit the scale of cycles and crises • Cycles have been becoming more damped • The risk of financial crises has not fallen

7. Enhancing growth and stability • Output depends on factor inputs and the efficiency with which they are used • Policy should increase supplies of factors • Increased competition increases efficiency • The national and international saving and investment balance determine real interest rates • Lower real interest rates increase capital and output • Lower risk premia increase the level of capital per unit of output • Crafts and O’Mahony show core Europeans have 25% more capital per head than the UK

8. Inflation and Risk • Lower inflation and output volatility reduces risk and affects decision making • Lower premia mean a lower cost of capital, more investment and a higher capital stock • Higher capital means more output for a given level of labour input • Exchange rate instability increases risk and reduces investment and output • Monetary union membership for the UK may raise inflation volatility and will reduce exchange rate volatility

9. Labour productivity in EU (person hour in ppp) relative to the US

10. Productivity and growth • Output per person hour is higher in core Europe than in the US or the UK • Over the last 30 years the core Europeans have caught up with and overtaken the US • UK performance has improved marginally recently

11. Participation, hours and activity • Participation rates are lower in core Europe than the US or the UK • Hours are shorter in core Europe • Methods of constructing the national accounts differ significantly • Core Europe has a lead in output

12. The events of the 1970s • The collapse of Bretton Woods was triggered by a German refusal to accept the inflation rate determined by US policy • Outcomes varied across Europe, but German policy was much more successful • Germany kept inflation stable • The UK and Italy performed badly • It is not clear that floating exchange rates were a success

13. Inflation

14. The ERM and the path to Union • Exchange rates became more stable in the 1980s with the ERM • Inflation began to converge but realignments were common • Exchange rates became harder • Fiscal policy had been loose in the 1980s • The Maastricht Treaty put constraints on fiscal policy • Deficits were limited • Debts had a ceiling • The ERM crisis of 1992 to 93 made the process look unstable

15. Choosing the members • In the early 1990’s plans involved a small membership with tight constraints • Fiscal constraints were the most important • Deficits had to be under 3% of GDP • The debt criteria disappeared • Exchange rate stability and interest rate convergence was required • These were not always imposed • Why was a deficit ceiling chosen, and what was wrong with the Golden rule

16. What is the constitution • The monetary constitution gives the ECB the right to choose its own inflation target • Is this a democratic deficit • What are the role of rules • The background to the ECB must be seen in German Ordliberalism (not Mill and utility) where rules constrain politicians • The three pillars of the constitution are price stability, competition and the constrained state with dispersed responsibility

17. EMU and the single market • The Common Market has always been more than a free trade area, and it involved integration of standards and rules • The single market has removed barriers to trade and to capital mobility • It was designed to enhance competition • Competition reduces rents and raises output • The first phase increased trade • The removal of the currency barrier was the last step and appears to have increased cross border capital mobility

18. Fiscal Pacts in EuropeBackground • Debt stocks rose to high levels by the early 1990s raising real interest rates • Debt stocks rose because fiscal policy was expected to reduce unemployment • High unemployment was structural not cyclical and fiscal policy did not work • Lower debt was needed to help reduce real interest rates and raise equilibrium output • Labour market polices were needed to deal with structural unemployment

19. Why do we need Fiscal Pacts • Governments need fiscal pacts with their people to enhance growth • The assurance of no excessive borrowing reduces expected real interest rates • Lower borrowing reduces the risk premium • It lowers the risk of default • it reduces the pressure for higher inflation to be used to reduce the debt burden • The UK has a Fiscal Pact between the people and the state based on the Golden rule • Does the golden rule have any basis in economic theory or it is just a guideline

20. Why does EMU need a Pact • In Monetary Union the gains from fiscal expansion are mainly in the home country • Spillovers are shared by all members • Increased real interest rates are shared, and in the long run reduce output everywhere • The costs of higher inflation are shared because of the pressure of the risk of debt default are shared everywhere • Default risks lie with the country and the lenders not the Euro Area

21. EMU and monetary target independence • The ECB has the constitutional remit of maintaining price stability • It started with a range of 0-2 per cent but was clear that this was not centred at 1.0 • It now has a target of close to but below 2.0 • How can 2 per cent be price stability • Why does price stability matter • Longer term contracts are secure • Second round effects from oil seem limited • What are the achievements

22. Monetary Policy • Monetary policy is handled to the ECB • It has goal and instrument independence • It is not clear that it is fully effective • Policy under the Bundesbank was clear • Behaviour was constant over 25 years, • Inflation and its volatility were the lowest in the G7 • Real exchange rate volatility was low • ECB behaviour is clearly different • It appears to have less response to deviations of inflation above and below target

23. Euro Area Inflation Expectations • Since oil price began to rise • US inflation expectations up 0.7 pp on average p.a. over next 10 years, and 1 pp over next 5 years • Euro Area expectations up just ¼ pp • Exchange rate developments • The decline in the dollar raise US inflation expectations • Monetary policy regimes • The US may be expected to be more accommodating • Different cyclical positions

24. Has EMU been a success? • We need to judge EMU on growth, stability and inflation • Has inflation been near target • Has the exchange rate been stable • Has growth been satisfactory • We also need to ask what else has been going on, and how this affected individual countries ands the Union as a whole • Globalisation and trade agreements • Technical change and new products

25. Inflation performance

26. Fiscal policy – has the SGP worked

27. Why and where has growth been weak • Growth has been weak in Germany and Italy and recently in the Netherlands • Performance in France has been OK and robust in Spain and Finland • Overall growth has been weak but this may not be because EMU has been set up

28. Misalignments and the effects of entry • Overvalued currencies on entry would have caused slower growth • Germany and Italy were overvalued, Netherlands and Spain undervalued • Growth differentials partly reflect adjustment • Germany controlled policy until 1999, and it was designed to reduce volatility there • EMU will have raised perceived volatility in Germany but reduced it elsewhere • All these should net out leaving growth for EMU unchanged

29. Technical progress and productivity growth • Germany has had slow growth in labour productivity • blamed on inflexible labour markets • Other countries in EMU are similar • The US has had a wave of technical progress raising labour productivity • The US moved first with new products, and its education system and labour market were more suited to these developments

30. Trade and globalisation • World trade agreements have changed potential output in EMU • Italy has been badly hit by the ATC because of its production structure • Italy has had very major fiscal consolidation over the last decade

31. Products and processes • The world economy has been going through a period of product innovation after decades of process innovation • EMU may have slow growth because of the design of its institutions • Long term attachments between firms and workers with extensive on the job training are different from the US pattern • EMU styles may be better for process innovation and it may be unwise to change • We may have seen waves of catching up and falling behind because of these difference

32. Will expansion make EMU more difficult to sustain • Estonia, Lithuania and Slovenia may join this year if inflation and budget deficits allow them to do so • Why are they joining and will it change anything – in this case not much • Poland, Czech Republic and Hungary will join by 2010 – Poland is half of NMS • For given inflation in core Europe they mat raise the required inflation target by 0.06 initially and 0.2 perhaps in 2010 • These expansions will be easier to manage than the inclusion of Italy and Spain at the outset

33. Does it matter that the UK is outside EMU • The SMP and economic integration is not complete without UK membership • The costs to EMU are likely to be small • The costs to the UK may exist • It is not clear that the UK will be more stable and grow more outside EMU but costs of staying outside will be low • Real exchange rate stability is less likely outside and this is the major factor affecting investment risk premia

34. Conclusion – what will happen to EMU • Exchange rate regimes fall apart slightly more often than countries do • The economic benefits are clear, but the political will has to remain • It is not clear that Italy would find life any more comfortable outside EMU, but devaluation and inflation can help when you have structural problems • EMU may be a better option than a repetition of 1933 to 1945

35. Economics and Business ExchangeSupported by Deloitte.