TU-91.2043 International Economics by Hannele Wallenius

1. 5 MONETARY UNIONS TU-91.2043 International EconomicsbyHannele Wallenius

2. 5 MONETARY UNIONS • 5.1 EMU • 5.2 Optimal Currency Areas • 5.3 Cost of Common Currency

3. 5.1 EMU (Economic and Monetary Union) • On January 1, 1999* eleven member countries of EU adopted a common currency, Euro • 2001 Greece, 2007 Slovenia and Cyprus, 2008 Malta, 2009 Slovakia, 2011 Estonia, and 2014 Latvia joined the EMU • The birth of the Euro resulted in fixed exchange rates between all EMU member countries • By giving up national currencies they handed over control of their monetary policies to ECB *EMU was established in three phases: coordinating economic policy, achieving economic convergence (!?) and culminating with the adoption of the euro 1.1.2002.

4. How and why did Europe set up its single currency? • War-torn history of Europe is the main contributor for both the market and monetary unification • After the Bretton Woods system’s breakdown (1971) currencies, in principle, floated freely against dollar

5. EU countries, however, progressively tried to narrow the extent to which they let their currencies fluctuate against each other Warner committee (1969) started the drive toward European monetary policy* the “snake”, a European informal joint float against dollar European Monetary System (EMS) 1979-1998, a formal network of mutually pegged exchange rates (ERM) * Interestingly, already in the League of Nations, Gustav Stresemann asked in 1929 for an European currency because of an increased economic division due to a number of new nation states in Europe after the Treaty of Versailles

6. Two Main Motives for Single Currency: 1. To enhance Europe’s role in the world monetary system. • EU countries hoped to defend more effectively their economic interests in the face of an increasingly self-absorbed US 2. To turn the European Union into truly unified market. • It was believed that exchange rate uncertainty was a major factor reducing trade within Europe

7. To turn the European Union into truly unified market... Building blocks of an integrated competitive market. • free trade in goods • free trade in services • free mobility of capital • free mobility of labor Market competition leads to common prices across the union, which leads to optimal allocation of resources increasing welfare and economic growth. BUT existence of separate national currencies, often subjects countries to erratic exchange rate changes, causes random price fluctuations which disturb the integration process.

8. Why was EMS not enough? 1. Single currency was believed to produce a greater degree of European market integration than fixed exchange rates • by removing the threat of EMS currency realignments and eliminating the cost of converting one EMS currency into another

9. Why was EMS not enough? continued 2. Some EU leaders feared too large of a dominance of German Bundesbank emphasizing German macroeconomic goals. 3. Given the free capital movements, maintaining fixed exchange rates single currency was the best solution.

10. Why was EMS not enough? continued 4. Political stability of Europe • single currency seen as a potent symbol of Europe’s desire to place cooperation ahead of the national rivalries that often had led to war in the past

11. 5 MONETARY UNIONS • 5.1 EMU • 5.2 Optimal Currency Areas • 5.3 Cost of Common Currency

12. 5.2 Optimum Currency Areas • Theory originally developed by Robert Mundell in 1961 • Fixed exchange rates within a region, floating between regions • According to the theory of OCA, fixed exchange rates are most appropriate for areas closely integrated through international trade and factor movements

13. OCA Criteria • Extent of trade • Similarity of shocks and business cycles • Degree of labor mobility • System of fiscal transfers

14. Benefits of a Monetary Union • Elimination of transaction costs of changing one currency into another in inter-country trade • Transparency of prices • Increased competition • Reduced exchange rate uncertainty • Elimination of hedging costs • Risk-averse parties engage in more trade • Low inflation, standardization of interest rates • Increased policy credibility from the elimination of devaluations

15. Costs of a Monetary Union • Loss of national monetary policy • If wage inflexibility and labor immobility unemployment and inflation • Different labor market structures • Raising (government) revenue through inflation not possible any more • Switching costs • administrative, legal, hardware • psychological • Wrong fixed rate

16. Benefits and Costs of Monetary Integration • Lines B and C represent the benefits and costs of the monetary integration, respectively. E is the point where benefits = costs Through time increased competition in a common market (induced by factor movement, price flexibility, increased trade)will lead decreased costs and increasing potential benefits of the union. H H* Costs, Benefits B E E* is reached after monetary integration. E* C C* Trade/GDP ratio Line H through E divides the are of the diagram into two sectors: to the left of H, the costs exceed the benefits, C > B; and visa versa to the right of H. So a country should be on the right of H to joint the union.

17. Is the EMU an OCA? • Openness and diversification • large trade to GDP ratios • intra-EMU trade • Similarity of shocks? • Examples of asymmetric shocks: • unification of Germany • the collapse of Soviet union • current debt crises in EU…

18. Is the EMU an OCA?Continued • Labor mobility • greatly insufficient! • System of fiscal transfers • no formal system as of yet, but what will the ESM (European Stability Mechanism)* bring along? *ESM is a permanent crisis resolution mechanism for the euro area. The ESM issues debt instruments in order to finance loans and other forms of financial assistance to euro area Members States.

19. Possible Convergence within EMU • EMU not an OCA ex ante but maybe ex post • OCA criteria are jointly endogenous: If a customs union establishes a single market and progresses to an economic union, its internal trade intensity and interdependence between its members rise and become increasingly correlated with symmetry in business cycles as member countries progressively become more similar (Frankel and Rose, 1998)

20. Why problems of operating a common monetary policy might not be too serious • There is greater divergence within member countries than between, and thus shocks can be more damaging within countries (e.g. effects on coal industry): i.e. shocks are more likely to hit individual industries or regions rather than individual countries • Thus changing the exchange rate (devaluation/revaluation) would be the wrong policy tool When doubts about EMU were presented, counter argument was…

21. The effects of monetary policy changes are likely to become more similar over time as the single market (in finance) develops The Euro will cause greater convergence, and therefore common monetary policy will become more and more appropriate over time. To day we know that there was not enough convergence, but instead too low interest rates for some and too much independent national fiscal policy (read: too much borrowing and living on debt…

22. 7 MONETARY UNIONS • 5.1 EMU • 5.2 Optimal Currency Areas • 5.3 Cost of Common Currency

23. 5.3 Cost of a Common Currency: An Illustration • How to cure asymmetric shocks? • Devaluation or revaluation of a currency in EU trade is not possible any more... neither can we determine the quantity of national money in circulation, i.e. we have lost the ability to conduct a national monetary policy

24. A Two Country Monetary Union • Let's assume that Euroland consumers shift their preferences away from Finnish-made to German-made products: ADF and ADG Finland Germany PF PG ASF ASG ADG ADF YG YF

25. Both countries will face an adjustment problem: • Finland is plagued by unemployment and current account deficit. 2) Germany experiences a boom  inflation and current account surplus.

26. Cost of a Common Currency continued • Is there a mechanism that leads to an automatic equilibrium without devaluation/revaluation? • YES, if there is: 1)wage flexibility 2)labor mobility

27. Wage flexibilitywould shift the aggregate supply curves of the countries in opposite directions bringing countries back towards the equilibrium • There would also besecond-order effectson aggregate demand: wages and prices in Germany would increase making Finnish products more competitive and so increasing AD in Finland and decreasing AD in Germany

28. Labor mobilitywould eliminate the need for wage rate changes, instead Finns simply would move to Germany to work! • But if wage flexibility and/or labor mobility are not sufficiently high the adjustment problem will not vanish • Instead now the adjustment to the disequilibrium will take the form of inflation in Germany

29. And if German authorities do care of inflation, they want to resist these inflationary pressures (by restrictive monetary and fiscal policies) • But their current account problems will not disappear • Revaluation in Germany or devaluation in Finland would solve this dilemma, but that’s now impossible!

30. Can we solve the dilemma by using some other instruments? In principle, yes: Germany could increase taxes to reduce its aggregate demand and transfer these revenues to Finland where they would be spent to increase Finnish aggregate demand !!!! This would mean federalism in EU…

31. Let’s take a look back. Note this is from 1999: The Future of EMU: What Does the History of Monetary Unions Tell Us?NBER Working Paper No. 7365, September 1999 • The creation of EMU and the ECB has triggered a discussion of the future of EMU. Independent observers have pointed to a number of shortcomings or hazard areas' in the construction of EMU: • absence of a central lender of last resort function for EMU • the lack of a central authority supervising the financial systems of EMU • unclear and inconsistent policy guidelines for the ECB • the absence of central co-ordination of fiscal policies within EMU • unduly strict criteria for domestic debt and deficits, as set out in the Maastricht rules, in the face of asymmetric shocks, and Euroland as not an optimal' currency area

32. NBER Working Paper No. 7365, September 1999, continued… Do these 'flaws' represent major threats to the future of EMU? • Or will they be successfully resolved by the European policy authorities, leading to a lasting and prosperous EMU? • Our main lesson from the history of monetary unions is that political factors will be the central determinants of the future of EMU. The 'economic' shortcomings of EMU will likely be overcome as long as political unity prevails within EMU

33. Note, now we turn to present situation. Design Faults of EURO Project (by Philip Arestis, Malcolm Sawyer, 2011) • Convergence criteria focus on nominal rather than real variables and pay no attention • to the validity of the exchange rates at which countries enter the EMU • or to the prevailing current account deficits and surpluses • nor to the differences in inflation mechanisms between countries • inadequacy of a fiscal policy based on numerical targets operating at the national level

34. And now we are here… Commission proposes new ECB powers for banking supervision as part of a banking union • On 12 Sep. 2012 the Commission proposed a single supervisory mechanism (SSM) for banks led by ECB in order to strengthen EMU • First step towards an integrated “banking union” which includes further components such as a single rulebook, common deposit protection and a single bank resolution mechanisms • On 19 Dec.12.2013 council agrees general approach on Single Resolution Mechanism (SRM). Negotiations with the European Parliament will start in early 2014 to allow for its adoption before the end of the current legislative period

35. Emerging stronger from the crisis: the European vision http://youtu.be/0B3zNcFYqj0