European Economic and Monetary Integration EXAM DATE

1. European Economic and Monetary Integration EXAM DATE • Exam: April 17 at 18.00 • C401-402-403-404

2. Decision-Making • The logic of regional currency calls for a single central agency with strong supranational powers • Fully Dollarized countries cede all powers to the central bank of the country whose currency they use • The relationship is hierarchial • No guarantee that the anchor country will take their views into account when decisions are made • For instance, ECB and ECCU’s central bank ECCB is based on a principle of parity, relationship of equals but the central bank still has the final say

3. Decision-Making (cont.) • Near-dollarized countries have monetary agencies but without significant powers • Currency Board countries have less demanding rules which give them more discretion (not entirely one-sided)

4. Costs vs. Benefits • Economic Factors • Transaction Costs (favors currency regionalization) • Reduction in transaction costs in regionalization • Expenses related to searching, bargaining, uncertainty and enforcement of contracts, currency conversion and hedging no longer needed • Trade could increase • Leads to efficiency gains • Also leads to economies of scale of using a single currency • Reduction in administrative costs because a separate structure is no longer needed for a separate currency • A firmer financial sector is established (stability) – no big price ups and downs or currency revaluations • Reduction in interest rates for local borrowers

5. Economic Factors (cont.) • Macroeconomic Stabilization (does not favor currency regionalization) • The loss of autonomous monetary policy to manage the economy • Governments give up control of money supply and exchange rate policy to cope with domestic or external disturbances • Distribution of Seigniorage (does not favor currency regionalization) • Spending power that accrues from the state’s ability to create money • This is a pure profit of the central bank • In regionalization governments either give this up completely or divert it to a joint institution

6. Costs vs. Benefits (cont.) • Political Factors • Social Symbolism (does not favor currency regionalization) • Money plays a powerful role in helping to promote a sense of national identity • Also has a psychological value • Most communities have an emotional attachment to their currencies • This would be compromised in terms of regionalization

8. Political Factors (cont.) • Diplomatic Influence (does not favor currency regionalization) • Money is command over real resources • If a nation can be threatened with denial of access to the means of acquire goods and services it will be vulnerable in geopolitic terms • Monetary sovereignty enables policy makers to avoid dependence on some other source for their purchasing power

9. Costs vs. Benefits (cont.) • Taking all five factors into account there are two implications • It is clear why so many states still want to produce their own money • Reduction in transaction costs, on its own, would seem unlikely to outweigh the other factors • It is evident why there is such wide variation in the design of regional currencies • Lower degree of regionalization helps to alleviate some of the perceived disadvantages

10. Costs vs. Benefits (cont.) • At issue are state preferences. • Although policymakers can be expected to vary the weights they attach to each factor, empirical studies show that 3 conditions are key components in behavior: • Country Size • Of all the economies that were fully or near-dollarized the largest was Ecuador – a population of about 13.5 million • Most are tiny enclaves or microstates • Small size also dominates among nations with currency boards or bimonetary systems

11. Country Size (cont.) • The smaller the economy’s size (population, territory, GDP...) the greater is the possibility of regionalization • Logic: smaller states are least able to sustain a competitive national currency since these coutnries are already vulnerable in political terms the risks attached to dependence are bearable • Indeed, they may even see advange in the protection of an association

12. Populations of Fully Dollarized and Near Dollarized Countries

13. Costs vs. Benefits (cont.) • Economic Linkages • Many countries that make use of a popular foreign currency have long been closely tied to a market leader economically • For ex. EU had deep linkages before the monetary union • This increases the possibility of government surrendering privilege of producing its own money • The higher the level of interaction the more likely we will see economic convergence

14. Costs vs. Benefits (cont.) • Political Linkages • The intensity of political linkages also effects the decision to regionalize • Ties may take the form of patron-client relationships • For ex. Ex-colonies often descended from previous colonial relationships • Majority of fully dollarized or near-dollarized economies and 3 out of 4 monetary unions (other than the EMU) originated in colonial times or in UN trusteeship • Closer political bonds will increase the probability that a government will be prepared to surrender the privilege of a national money • Political linkages reduce the costs associated with the loss of a social symbol and the increase of vulnerability to outside influence

15. Costs vs. Benefits (cont.) • (and a possible 4th condition) Domestic Politics • Material interests of specific interest groups are influenced by what a government decides to do with its money • Therefore, interest-group preferences are important • The greater the influence of integrationist interests the more probable it is that policymakers will be prepared to delegate monetary authority

16. Conclusion • Future of monetary governance in a world of regional currencies: • Even though deterritorialization of currency is imposing constraints on traditional monetary governance it does not dictate the choice a government will make • There should be relatively few cases of pure dollarization or currency unification (EMU is an exception) – governments will probably prefer mixed models

17. Conclusion (cont.) • Mixed models will depend on the coutnry and its bargaining context • Bargaining context will depend on country size, economic linkages, political linkages and domestic politics

18. Costs of a Common Currency • When a country relinquishes its national currency, it also relinquishes an instrument of economic policy • It loses its ability to conduct a national monetary policy • Nation in a monetary union can no longer change the price of its currency • Or determine the quantity of the national money in circulation • The use of exchange rates as a policy instrument is useful because nations are different in some important senses requiring changes in the exchange rate to occur

19. Theory of Optimum Currency Areas • Pioneered by Mundell (1961), McKinnon (1963), Kenen (1969) Professor Ronald I. McKinnon Professor Peter Kenen Professor Robert Mundell, 1999 Nobel Laureate: the father of the Theory of Optimum Currency Areas.

20. Optimum Currency Areas • Shifts in Demand (Mundell) • EU consumers shift their preferences from French-made to German-made products: Asymmetric Shock

21. Asymmetric Shock

22. Asymmetric Shock • Demand Curve: negatively sloped line indicating that when the domestic price level increases the demand for domestic output declines • Supply Curve: when the price of the domestic output increases domestic firms will increase their supply to profit from the higher price • Assumes competition in the output markets • Demand Shift: upward movement in Germany; downward movement in France • Output declines in France, increases in Germany • Unemployment increases in France and decreases in Germany

23. Asymmetric Shock (cont.) • There is an adjustment problem in both countries • France: • unemployment • current account deficit • Germany: • upward pressures on price levels • current account surplus

24. Asymmetric Shocks (cont.) • Is there a way to get automatic equilibrium without resorting to devaluations and evaluations? • 2 mechanisms: • Wage Flexibility • If wages are flexible, French workers who are unemployed will reduce their wage claims • In Germany the excess demand for labor will push up the wage rate • Mobility of Labor

25. Wage Flexibility Increase in wages shifts the supply curve upward Reduction of wage rate shifts supply curve downward

26. Wage Flexibility (cont.) • Once the French supply curve shifts downward and the German supply curve shifts upward – equilibrium is supplied: • French output prices decrease • French products become more competitive • Demand stimulated current account deficit improved • Opposite happens in Germany • German output prices increase • German products become less competitive • Current Account surplus is reduced

27. Adjusting for Asymmetric Shocks • Mobility of Labor • French unemployed workers move to Germany where there is excess demand for labor • This eliminates the need for wage decline in France and wage increases in Germany • Unemployment problem in France solved • Inflation problem in Germany sovled • Current Account disequilibrium dissapears

28. Asymmetric Shocks (cont.) • In the principle of adjustment the problem for France and Germany will dissapear automatically if: • wages are flexible and/or • if the mobility of labor between the two countries is high

29. Asymmetric Shocks (cont.) • If this does not happen then both countries have an equilibrium problem (leading to German price increases): • Wages in France do not decline despite unemployment • French workers do not move to Germany • Germany’s excess demand for labor puts upward pressure on wages • Germany must increase prices to adjust to the disequilibrium • High German prices make French goods competitive again • Upward shift in the demand curve of France

30. Asymmetric Shocks (cont.) • If wages do not decline in France the adjustment to the disequilibria will take the form of inflation in Germany • Germany then faces a dilemma: • High inflation OR • (to eliminate this they need to use restrictive monetary and fiscal politicies but this will mean) – Current Account Surplus • Current Account Surplus • (elimination of this means higher inflation)

31. Asymmetric Shocks (cont.) • Dilemma can only be solved by revaluing the Deutsche Mark against the French Franc: • This reduces demand in Germany and increases competition for French goods

32. Currency Revaluation • France solves its unemployment problem • Germany avoids inflationary pressures • Current account disequilibria disappears

33. Currency Revaluation • If France does not have control over its exchange rate because of joining a monetary union with Germany: • France will have an unemployment problem • And a current account deficit • This can only disappear by deflation • Monetary union has a cost for France when faced with a negative demand shock • Germany will find it costly to be in a uinon due to the inflationary pressures

34. Monetary Independence and Government Budgets • When countries join a monetary union they lose their monetary independence • This affects their capacity to deal with asymmetric shocks • It also has another implication: it changes the capacity of governments to finance their budget deficits • Members of a monetary union issue debt in a currency over which they have no control (in the case of the Eurozone - €) • This implies that financial markets acquire the power to force default on these countries • Would not have been the case had they kept their own currency over which they had control when issuing debt

35. UK vs Spain – Fears of Government Debt Default • UK: • In such a situation the price of the pound would drop until investors were willing to rebuy it again • UK money stock would remain unchanged • If the UK government cannot find the funds to roll over its debt at reasonable interest rates it would force the Bank of England to provide it with the cash to pay out bondholders • UK government cannot be forced into default because of the Bank of England

36. UK vs Spain – Fears of Government Debt Default • Spain: • Member of the Eurozone – debt is in Euros • If investors fear default – they sell Spanish governent bonds, raising the interest rate • Investors can decide to take their euros and invest in another euro country (ie. Germany) – euros therefore leave the Spanish banking system • The money supply in Spain shrinks leading to a liquidity crisis for the Spanish government • The Bank of Spain cannot provide cash and the Spanish government does not have control over the European Central Bank • A strong enough liquidity crisis can force the Spainsh government into default – financial markets know this and test governments

37. UK vs Spain – Fears of Government Debt Default • Scenario shows us the fragility of monetary unions • When investors distrust a particular member government they will sell the bonds thereby raising the interest rate adn triggering a liquidity crisis • This may lead to a solvency problem: • With a higher interest rate the government debt burden increases, the government is forced to reduce spending and increase taxation • This is politically costly and may lead to a default • By entering a monetary union member countries become vulnerable to movements of distrust by investors

38. Currency Union and Budgetary Union • Another solution to the asymmetric shock dilemma: • Taxes increase in Germany (reducing aggregate demand) • Tax revenues are transferred to France where they are spent (increasing aggregate deman) • France’s current account deficit is financed by Germany • A budgetary union achieves two things: • Creates an insurance mechanism triggering income transfers from the country experiencing good times to the countries hit by bad luck • Allows consolidation of a significant part of national government debts and deficits thereby protecting its members from liquidity crises and forced defaults • This is obviously not a very likely solution • This solution is usually applied to regions of the same nation not between different nations • This is only a temporary solution

39. Fiscal Equalization Between Lander in Germany (2006)

40. MAIN POINTS • If wages are rigid and labor mobility is limited countries that form a monetary union will find it harder to adjust to demand shifts than countries that have maintained their own national moneys and that can devalue (and revalue) their currency • A monetary union between two or more countries is optimal if one of the following conditions is satisfied: • There is sufficient wage flexibility • There is sufficient mobility of labor

41. MAIN POINTS (cont.) • It also helps to form a monetary union if the budgetary process is sufficiently centralized so that transfers can be organized smoothly • (The other benefits of a monetary union are yet to be defined)

42. Different Preferences of Countries About Inflation and Unemployment • Countries have different preferences • Some are willing to accept more inflation than others • This makes the introduction of a common currency costly

43. Different Preferences about Inflation and Unemployment (cont.) • Fixed exchange rate unstable if the two countries involved have different preferences • 2 countries with different preferences (ex. Germany and Italy) now need to keep a fixed exchange rate and will need to choose another less desirable point on the Phillips Curve • They will have equal inflation • Italy will have less inflation and more unemployment • Germany will have more inflation and less unemployment • This analysis was popular in the 1960s and 1970s • Phillips Curve has since seen its demise and is accepted to be unstable

44. Differences in Labor Market Institutions • There are important institutional differences in the labor markets of European countries: • Highly centralized labor unions (ex: Germany) • De-centralized labor unions (ex: the UK) • This may introduce significant costs to a monetary union • Institutional differences can lead to divergent wage and price developments even if countries face the same problems • Ex: oil price shock effect on domestic wage and prices depends on how labor unions react to these shocks

45. Differences in Labor Market Institutions (cont.) • Bruno and Sachs (1985): macroeconomic theory of the importance of labor market institutions: • Supply shocks have different macroeconomic effects depending upon the degree of centralization of wage bargaining • Corporatist (centralized wage bargaining) countries labor unions know about the inflationary effect of wage increases • Excessive wage claims lead to more inflation • Real wages do not increase • They have no incentive to do this

46. Differences in Labor Market Institutions (cont.) • Less centralized wage bargaining countries know that the effect of individual unions asking for higher wages is small (because they are only a small fraction of the labor force) • Free-riding problem • Each union tries to increase wages of its members because if it does not – their real wages will decline • Wage moderation following supply shocks is less likely in these countries • No individual union has incentive to reduce wage claims

47. Differences in Labor Market Institutions – MAIN POINTS • Countries with very different labor market institutions may find it costly to form a monetary union because with each supply shock wages and prices in these countries may be affected differently making it difficult to correct for these differences when the exchange rate is irrevocably fixed

48. Differences in Legal Systems • Despite integration, member states of the EU have very different legal systems • Sometimes these differences can have important effects on the way markets function • Examples: • Mortgage markets: legal systems regarding mortgage markets differ from one state to the next • Some states offer more protection to banks extending mortgage loans • This gives a different amount of risk to mortgages according to which country they are in • 100% collateral required in some countries while in other countries substantially less collateral is required • İnterest adjustments are also subject to legal differences where mortgages with floating interest rates exist in some countries and mortgages with flexible interest rates exist in other coutnries • Increase in interest rate by the ECB will have different effects in different countries of the union

49. Differences in Legal System examples • Company Financing • Companies differ in how they finance themselves • Countries with an Anglo-Saxon legal tradition: firms go directly to capital markets (bond and equity markets) – markets are well developed and very liquid • Countries with a Continental European legal tradition – firms go to the banking system for financing – capital markets are less developed • Interest rate disturbances are transmitted very differently among member states • Increase in interest rates: • Anglo-Saxon system: large wealth effects consumers because they hold lots of bonds and stocks (increase – lowers bond and stock prices and wealth declines) • Continental system: less effects (consumers will mainly be affected in their bank-lending spending) – increase means borrowers are unable to borrow all they want or none at all

50. Differences in Growth Rates • Some countries grow faster than others