Benefits of a Common Currency

1. Benefits of a Common Currency • Costs have to do with macroeconomic management of the economy • Benefits have to do with the microeconomic aspect • Eliminating national currencies for a common currency leads to economic efficiency gains • Elimination of transaction costs • Elimination of exchange rate risk

2. Benefits of a Common Currency (cont.) • Direct gains from the elimination of transaction costs • Eliminating the costs of exchanging one currency into another is themost visible gain from a monetary union • E.C. Estimates these gains between €13-20 billion/year • Of course banks will lose revenue they get for exchanging national currencies in a monetary union

3. Benefits of a Common Currency (cont.) • Indirect gains from the elimination of transaction costs • The scope for price discrimination between national markets will be reduced • The unification of currency along with the other measures in creating a single market will make price discrimination more difficult • This is a benefit to the European consumer

4. Benefits of a Common Currency (cont.) • Welfare gains from less uncertainty • The uncertainty about future exchange rate cahnges introduces uncertainty about future firm revenues • Welfare of firms will increase when common currency is introduced (exception: firms taht make money by taking on risk)

5. Benefits of a Common Currency (cont.) • Exchange Rate Uncertainty and the Price Mechanism • Exchange rate uncertainty introduces uncertainty about the future prices of goods and services • Movement towards a common currency will eliminate the exchange risk and lead to a more efficient working of the price mechanism

6. Benefits of a Common Currency (cont.) • Exchange Rate Uncertainty and Economic Growth • The elimination of the exchange risk will lead to an increase in economic growth (the EC argument) • However, this view lacks empirical data

7. Benefits of a Common Currency (cont.) • Benefits of An International Currency • When countries form a monetary union the new currency will likely weigh more in international monetary relations than the sum of individual currencies prior to the Union • The currency is likely to find use outside of the union • This creates additional benefits to the union: • Issuer of currency obtains additional revenues • It will boost activity for domestic financial markets (foreign residents will want to invest – this creates know-how and jobs & financial institutions will have new opportunities

8. Benefits of a Common Currency (cont.) • Benefits of a Monetary Union and the Openness of Countries • The welfare gains of a monetary union are likely to increase with the degree of openness of an economy • Ex: elimination of transaction costs will benefit those countries that buy and sell a large number of goods and services in foreign countries • With an increasing openness towards the other partners in the Union, the gains from a monetary union (per uniot of output increases)

9. Costs and Benefits Compared

10. Costs and Benefits Compared (cont.) • The importance of costs and benfits depends on one’s view about the effectiveness of the exhange rate instrument • Monetarist View: • Exchange rate changes are ineffective as instruments to correct for these different developments between countries • Even if they are effective they make countries worse off

11. Monetarist View

12. Keynesian View • The world is full of rigidities (wages and prices are rigid, labor is immobile) – this makes the exchange rate a powerful instrument • Mundell’s original theory represents this very well • Few countries would benefit from a monetary union • Large countries with one currency would be better off (economically) splitting the country into different monetary zones

13. Keynesian View

14. Monetarist View and Keynesian View Compared • The monetarist view has been in favor with economists since the early 1980s

15. Is the EU an OCA?

16. Is the EU and OCA? (cont.) • Large differences in openness of EU countries with the rest of the Union • Cost-benefit graph will be different for each country • Most beneficial for the most open countries (ex. Benelux, Ireland) • For other countries like Italy with lower openness, their authorities obviously did not consider the loss of the exchange rate instrument costly and therefore decided to join the Union

17. Price and Wage Rigidities, Labor Mobility and Monetary Union • Cost-Benefit calculus of a monetary union is also influenced by the degree of wage and price rigidities

18. Price and Wage Rigidities, Labor Mobility and Monetary Union (cont.) • An increase in the degree of mobility of labor shifts the cost curve to the left and makes the monetary union more attractive • Single market with labor mobility makes the EMU more attractive • However, regional concentration of industrial activities (like that of auto production in one country) would shift the cost curve upwards

19. Asymmetric Shocks and Labor Market Flexibility • The size and frequency of asymmetric shocks also matters for the attractivenss of a monetary union • Countries that have very different demand and supply shocks will find it more costly to join a monetary union • Their cost line would shift upwards

20. Asymmetric Shocks (cont.) 17 6 6 2011 17

21. Asymmetric Shocks (cont.) • Countries (regions) that experience a high divergence in output and employment growth need a lot of flexibility in their labor markets if they want to benefit from a monetary union • As the degree of divergence goes up – the greater the need for flexibility in labor markets • This relationship is shown by the line AA • Empirically, EU-15 (and EU-27) as a whole is located above the AA line – from an economic point of view, a monetary union is a bad idea • However, there is a subset of countries which do form an OCA (EU-5: Benelux, Germany and France)

22. Is the EU an OCA? • The challenge for the EU is to move to the other side of the AA line • Two strategies: • Reduce the degree of real divergence • Difficulty: dependent on factors over which policy-makers have little influence (ex: industrial specialization) • Increase the degree of flexibility • Requires reform of labor market institutions (difficult but necessary) • However, by moving towards closer political unification asymmetric shocks could be reduced

23. Labor Unions and Monetary Union • Role of labor unions in determining the cost of a monetary union is significant • Presence of asymmetric shocks: • wages shoudl be flexible • Centralized wage bargaining harmful • ex: German unification (E. German firms did not survive the shock of unification) • Presence of symmetric shocks: • Wages should be more uniform across countries • Wage bargaining is still not desirable because: • Asymmetric shocks less likely in unified Europe but regional specializaiton could lead to asymmetries • Uneven changes in output and employment between sectors (sectors with less favorable developments would suffer) • Future organization of labor unions in a monetary union will have to respect the requirements of flexibility

24. Costs and Benefits in the Long Run 17 6

25. Costs and Benefits in the Long Run (cont.) 17 13 6

26. The Challenge of Enlargement of EMU • Since Eurozone is in existence the question of whether or not it is optimal is academic • Still important to know, however, whether or not the beneifts of the union exceed the costs for the 17 members • If costs do not exceed benefits individual members will be quite unhappy with the ECB • Enlargement of the EMU may exacerbate problems of ECB • Present Eurozone consists of 17 members • Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain (1999) • Greece (2001); Slovenia (2007); Cyprus, Malta (2008), Slovakia (2009), Estonia (2011)

27. The Challenge of the Enlargement of the EMU (cont.) • Denmark, Sweden and the UK have not yet joined the EMU • Will all of these countries bring the enlarged Eurozone closer to an optimal currency area? • Degree of Openness: • Central European countries are at least as open towards the EU as the EU countries themselves • Central European countries appear to be more integrated with the EU than Denmark, Sweden and the UK • Thus, in terms of openness, the Central European countries would fit quite well into the existing EMU

28. The Challenge of the Enlargement of the EMU (cont.) • Asymmetry of Shocks: • Study of Korhonen and Fidrmuc (2001) analyzed the correlation of demand and supply shocks with the average of the union for the EU states and candidates • Study finds high correlations of the large coutnries (France, Italy and Germany) with the euro area • Not surprising since these large coutnries make up a significant part of the Union • Although some Central European countries (Hungary and Estonia) are well correlated with the euro area, this is much less the case with others • A large number of states have negative correlations of their demand shocks (Lithuania, Latvia, Czech Republic, Slovenia and Slovakia) • This could be because these states pursue independent monetary policies – once in the Union this source of asymmetric shocks will dissapear • But the supply shock negative correlation is unlikely to disappear

29. The Challenge of the Enlargement of the EMU (cont.) • The position of the UK: • Correlation of demand shock is also negative – this reflects UK’s pursuit of its own national monetary policies quite independently from what happens in the Euro area • Correlation of the supply shock is also quite low • Conclusions: • It is not clear that all countries in the sample are part of an OCA with the rest of the EU • (most evident for the UK) – low trade with the euro area and is more subjected to asymmetric shocks than other large members of the Union – hesitation of the UK to enter the EMU is understandable • Despite the openness of the Central European states to the EU many of these countries are still subjected to relatively large asymmetric shocks • Some of these countries may still enter the EMU however as the best possible way to import monetary and price stability

30. Conclusions • It is unlikely that the EU as a whole constitutes an OCA • The number of countries that benefit from monetary union is probably larger than most economists thought just a few years ago • As the years increase, monetary union will become a more attractive option for most, if not all EU countries • Even the countries that are net gainers from a monetary union take a risk by joining the union • When large shocks occur they will find it more difficult to adjust

31. European Central Bank • In the postwar period 2 models of central banking have evolved: • Anglo-French model • Objectives: • Central banks pursue several objectives: • Price stabilization • Stabilization of the business cycle • Maintenance of high employment • Financial stability • Institutional Design: • Political dependence of central bank • Monetary decisions are subject to the governments approval • German model • Objectives: • Only one objective: Price Stability • Institutional Design: • Political Independence – no interference from political authorities

32. European Central Bank (cont.) • When the European nations negotiated the Maastricht Treaty a choice between these two models had to be made and the German model prevailed as the choice for the ECB • ECB objectives: • Article 105 of Maastricht Treaty states that it is “price stability” • Article 2 includes a “high level of employment” • Treaty recognizes the need to follow other objectives as well, but they are seen as secondary to “price stability” • Treaty is also clear on the need for political independence of the ECB • In the absence of this independence the central bank can be forced to print money to cover deficits – this would lead to inflation

33. European Central Bank (cont.) • The Bundesbank is clearly the model for the ECB, however, the ECB is tougher on inflation and political inflation than the Bundesbank was • Reason: a simple majority in German parliament can change the status of the Bundesbank, changes in the ECB are much more difficult • They can only occur by a revision of the Maastricht Treaty requiring unanimity among all EU-member states, including those that are not members of EMU

34. European Central Bank (cont.) • The success of the German model is intriguing • When the EU countries negotiated the Maastricht Treaty, the Anglo-French model prevailed in almost all of the EU-member states • It was rejected for the German model because: • Intellectual Development • The reaction to Keynes: the monetarist view erupted • It was felt that unemployment could not be lowered below its natural rate without creating inflation • Lowering unemployment below natural rate could only be achieved with structural policies like more flexibility in labor aned lower taxes • The central banks should only concentrate on what they can control: PRICES • It was demonstrated taht countries whose central banks were politically independent managed their economies better (lower inflation without high unemployment or lower growth

35. European Central Bank (cont.) • Strategic Position of Germany in the EMU Process • Germany faced the risk of having to accept higher inflation when they entered a monetary union • In order to reduce this risk they insisted on creating a central bank tough on inflation • In order to accept the EMU Germany insisted on having an ECB like the Bundesbank

36. European Central Bank (cont.) • ECB was thus modelled on the German Bundesbank with a strong mandate for price stability and weak responsibility for stabilizing output and employment functions • “conservative” central bank – an institution that attaches greater weight to price stability and lesser weight to output and employment stabilization than the rest of society

37. European Central Bank (cont.) • This leads to a conflict: • In hard times such as an unexpected recession taht increases unemployment the ECB will do little in terms of expansionary policies or less than what the society wants it to do • This represents a conflict between the ECB and elected politicians who represent the society • ECB will argue this gives them greater credibility because of their reluctance to yield to political pressure • This leads to a trade-off between credibility and stabilization

38. European Central Bank (cont.) • For the ECB monetary policies should not be used to lower unemployment below the natural unemployment • Politicians should do this by lowering taxes on labor and introducing flexibility in the labor market • The question and the problem is: “WHAT DOES THE ECB SEE AS THE NATURAL UNEMPLOYMENT RATE?” and is it correct in its assesment?

39. European Central Bank (cont.) • The Maastricht Treaty gave a mandate to the ECB to maintain price stability but also stabilize output and employment (provided this does not endanger price stability) • A wall was erected around the ECB to protect it from political interference so it could accomplish these objectives • Although there are good reasons for independence there are also problems associated with it – mainly, its lack of accountability • It is possible for the ECB to make a mistake, for ex to miscalculate the natural unemployment rate and therefore fail to stabilize output and employment while it could do so without endangering price stability

40. European Central Bank (cont.) • There needs to be a mechanism to check that the ECB fulfills its mandate and applies sanctions if this is not the case • If the government decided about interest rates there would be no need for accountability of the central bank • If the central bank has lots of power then there is a corresponding need for accountability since the government is accountable to the voters • Independence and accountability are part of the delagation of powers granted by voters

41. European Central Bank (cont.) Federal Reserve Bundesbank

42. European Central Bank (cont.) • Does the ECB have the strongest degree of accountability? • Evidence suggests that it is less well developed than that of the Federal Reserve Banking System of the USA (the Fed) • Although both presidents of these two banks face the parliament regularly the chairman of the Fed faces an institution that can change the status of the Fed by a simple majority – therefore he needs to pay attention to the opinions of Congressmen

43. European Central Bank (cont.) • When the president of the ECB appears before parliament they have no power to change its status – it can only be changed by changing the Treaty requiring a unanimity of all EU states – ECB has much more power • Thus ECB has lots of independence but not a corresponding degree of accountability

44. European Central Bank (cont.) • The other issue of accountability rises from the ECB’s objectives – they are not clearly defined • Although price stability is given as its objective it was not given a precise content making it possible for the ECB to define it itself • The other objectives of the ECB (provided price stability is achieved) have been left very vague • If this strategy of the ECB is successful it will only really be responsible for its performance against inflation

45. European Central Bank (cont.) • For ex. The Fed is responsible for movements in employment, mandated by law – unlike the ECB – the Fed has greater responsibility • The primary responsibilities of the Fed: • conducting the nation’s monetary policy to help maintain employment, keep prices stable, and keep interest rates relatively low • supervising and regulating banking institutions to make sure they are safe places for people to keep their money and to protect consumers’ credit rights. • providing financial services to depository institutions, the U.S. government, and foreign central banks, including playing a major role in clearing checks, processing electronic payments, and distributing coin and paper money to the nation's banks, credit unions, savings and loan associations, and savings banks.

46. The Federal Reserve System • The central bank of the United States • Created by Congress in 1913 • Consists of a network of twelve Federal Reserve Banks and a number of branches under the general oversight of the Board of Governors. The Reserve Banks are the operating arms of the central bank

47. The Federal Reserve System Districts

48. European Central Bank • In summary the accountability of the ECB is weak • Absence of strong political institutions in Europe capable of exerting control over its performance • As a result of the Treaty’s vagueness in defining its objectives the ECB has restricted its area of responsibility to inflation

49. European Central Bank (cont.) • This creates a long-term problem for the political support of the ECB • Most central banks are responsible for macroeconomic stability: reducing business cycle fluctuations, avoiding deflation, managing financial stability,... • Difficult to see how European politicians will continue to support an institution to which great power has been delegated and over which they have so little control

50. European Central Bank (cont.) • Some things the ECB can do to avoid this: • To compensate for the lack of formal accoutnability it could enahnce informal accountability, ex. Have greater transparency (for ex – the ECB can inform the public about its objectives and how it will achieve them and openness in the decision-making process • The ECB has tried to do this with its monthly reports and press conferences by the ECB president • Publish the minutes of its meeting like th eFed showing the voting of members – but the ECB says it cannot due to an article in the Treaty that prohibits it from doing so • ECB could broaden its responsibility • ECB should announce its estimate for the natural unemployment rate giving the public something to measure it by