The impact of eurozone entry and the experience of eurozone member states by David Cobham,

1. The impact of eurozone entry and the experience of eurozone member states by David Cobham, Heriot-Watt University, Edinburgh Public lecture Comenius University Bratislava February 2008

2. Outline Introduction: • what monetary union means, costs and benefits • some historical background to European Monetary Union • how EMU works: the European Central Bank, its monetary policy strategy, monetary and fiscal policy The performance of the Eurozone so far: • growth, inflation • the exchange rate of the euro • internal variation between members • the operation of monetary policy The likely effects of entry: • the Maastricht criteria • how and why entry now is different from entry in 1999 • prospects for growth and inflation

3. Introduction Monetary union • single currency (or irrevocably fixed exchange rates with zero margins) • full capital mobility • union-level central bank taking monetary policy decisions • foreign exchange reserves pooled and managed by union-level central bank • basic deal underlying MU: country fixes its exchange rate permanently against partner countries, but loses ability to set national interest rate

4. Introduction Costs and benefits of monetary union • main cost is loss of exchange rate (and interest rate) as instruments of national policy • how big this cost is depends on factors such as (1) likelihood of asymmetric shocks of a kind which exchange rate changes can treat effectively - depends e.g. on whether future shocks likely to be national or industrial/regional, (2) openness of partner countries i.e. importance of trade flows between them - more openness makes exchange rate changes less effective • second cost is transitional unemployment cost of reducing inflation rate to the union inflation rate

5. Introduction • first benefit is reduction in uncertainty about exchange rate, which should lead to more trade and investment, with better international allocation of resources • second benefit is savings from (a) pooling of foreign exchange reserves - less reserves needed for sum of countries, (b) centralisation of monetary policy - less research and less decision-making needed with union, (c) reduction in transaction costs from single currency

6. Introduction • third benefit is improvement in macroeconomic policy from restructuring of policy arrangements in move to monetary union, eg monetary policy becomes more disciplined, more credible, hence lower inflation and lower interest rates • fourth benefit is increased price competition coming from increase in price transparency through single currency

7. Introduction Historical background • MU was hardly mentioned at start of Common Market • became issue in late 1960s when Bretton Woods system was breaking down, Common Agricultural Policy was struggling with realignments of franc, mark • formal objective of MU adopted 1969, Snake mechanism from 1972, but progress neither substantial nor inclusive • 1979 European Monetary System (Giscard, Schmidt) = framework for stabilising exchange rates of most EU members (not UK, but France and Italy as well as Germany, also Ireland, later Spain, Portugal, Finland…) • over time EMS becomes stronger and more successful, with less realignments, end of capital controls late 1980s • fundamental decisions on European Monetary Union taken in Maastricht Treaty negotiations December 1991

8. Introduction • major upheavals in European Monetary System 1992-93: exit of sterling (had entered only in 1990) and lira (returns 1996), repeated devaluations of smaller currencies, French franc survives but only with help of widening of bands, from 2.25% to 15%, in August 1993 • major currencies gradually return to pre-1992 parities, governments reaffirm commitment to EMU • European Monetary Institute set up 1994 becomes European Central Bank from 1998, infrastructure including TARGET payments system established • EMU starts operation Jan 1999; members Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Spain, Portugal (but not UK, Sweden, Denmark), Greece from 2001, Slovenia from 2007, Cyprus and Malta from 2008, others shortly (?)

9. Introduction How EMU works • union-level central bank = ECB • independent of EU Commission and of national governments, focusing on Eurozone economy • mandate to pursue price stability • decisions on monetary policy taken by Governing Council consisting of ECB Board (6 members, President, Vice-President, plus 4 others, all nominated by European Council for non-renewable terms of 8 years) and 13 governors of national central banks • monetary policy strategy is careful compromise between monetary targeting (as practised, more or less, by Bundesbank) and inflation targeting (as practised and advocated eg by Bank of England)

10. Introduction The relation between monetary policy and fiscal policy: • controversial issue before EMU and since • Maastricht Treaty criteria for entry to EMU included (imprecise) limits on budget deficits and debt • the deficit limit was then incorporated in the Stability and Growth Pact: governments should aim to balance budgets over cycle, and fiscal deficits should not exceed 3%; sanctions could be imposed on deficits over 3% unless mitigating circumstances e.g. severe recessions • basic argument: need to constrain national-based fiscal policy so centralised monetary policy can work properly • SGP criticised for reducing scope for national fiscal policy, when arguably more scope is needed because of lack of national monetary policy (interest/exchange rate)

11. Introduction • under pressure from large countries refusing to observe SGP, revisions agreed late March 2005: 3% def and 60% debt reference values remain, medium term budget objective ‘close to balance’ or in surplus, states to cut deficits and debt in good times, more emphasis on debt which should fall at sustainable rate towards 60% • but more scope for claiming special circumstances: negative growth instead of -2% growth; mitigating factors include spending on development aid, European policy goals (eg research), costs of European unification (German reunification), major pension reforms; plus more time to adjust before sanctions • issue still controversial; but revision has not produced feared excessive loosening of policy, may turn out okay

12. Eurozone performance Economic growth: - neither impressive nor disastrous, better from 2006 - but probably disappointing to those who expected EMU would help to stimulate growth Chart: data on real GDP growth from OECD Econ Survey December 2007 - 2007 data are estimates (on partial information) - 2008, 2009 are forecasts - Other EU 15 = Denmark, Sweden, UK (unweighted average) - Other Western Europe = Norway, Switzerland

14. Eurozone performance Inflation: - averages at 2.1% 1999-2007 - above ECB’s definition or price stability (inflation < 2%) - but below US though above UK - broadly satisfactory; more stable than USA or others Chart: data from OECD Econ Survey Dec 2007 as above

16. Eurozone performance Unemployment: - Eurozone unemployment consistently, stubbornly, higher than elsewhere Chart: data for standardised unemployment from OECD Econ Survey Dec 2007 as above

18. Eurozone performance Most striking feature is exchange rate: - strong depreciation of euro vs dollar 1999 to mid-2001 - strong appreciation of euro mid-2001to end-2004 - renewed appreciation of euro/depreciation of dollar in 2006, 2007 - movements against dollar are largest element in nominal effective exchange rate (weighted average) (2000=100) - real effective exchange rate (relative unit labour costs) broadly follows nominal rate (also 2000=100)

20. Eurozone performance These movements are a puzzle: - we do not understand well the movement of exchange rates at this frequency - we have no convincing explanation of these particular movements - they affect competitiveness of Eurozone-produced goods on world markets - but these effects seem so far to be less serious than might have been expected

21. Eurozone performance Internal variation between Eurozone members: - considerable variation in growth rates, esp Ireland faster, Italy slower, Germany slower then improves

23. Eurozone performance Internal variation between Eurozone members: - considerable variation in growth rates, esp Ireland faster, Italy slower, Germany slower then improves - considerable variation in inflation rates, esp. Ireland initially higher, Spain higher, Italy higher, Germany mostly lower

25. Eurozone performance Internal variation between Eurozone members: - considerable variation in growth rates, esp Ireland faster, Italy slower, Germany slower then improves - considerable variation in inflation rates, esp. Ireland initially higher, Spain higher, Italy higher, Germany mostly lower - hence considerable variation in real exchange rates (note all have 2000=100, we can compare growth trends but not relative levels)

27. Eurozone performance Bond yields: - yields on long term government bonds reflect to a large extent expectations of inflation, so we can use them as a proxy measure of the credibility of monetary policy – the lower the yields, the more credible the policy - variation over time, but Euro area typically well below USA but above Other Western Europe

29. Eurozone performance Internal variation between Eurozone members: - considerable variation in growth rates, esp Ireland faster, Italy slower, Germany slower then improves - considerable variation in inflation rates, esp. Ireland initially higher, Spain higher, Italy higher, Germany mostly lower - hence considerable variation in real exchange rates (note all have 2000=100, we can compare growth trends but not relative levels) - unemployment rates, less predictably: Ireland goes well below Eurozone average, but Italy goes below average from 2003, Germany above

31. Eurozone performance How does Slovakia compare? - since 2001 higher growth - initially much higher inflation, but now converged - higher unemployment, esp. since 2000 - bond yields higher but then converge so general picture is good growth but high unemployment, alongside nominal convergence

36. Eurozone performance The monetary policy of the ECB: • monetary policy strategy is careful compromise between monetary targeting and inflation targeting • basic evaluation of monetary policy involves estimation of Taylor rule to see whether interest rate responds strongly enough to inflation to prevent inflation getting out of control • for ECB answer seems to be yes, as for the Federal Reserve and the Bank of England • policy interest rate in Eurozone less variable than US and UK – reflecting greater stability of inflation – and there is some evidence that the ECB is less ‘inertial’ than the Fed or the BoE, which is probably desirable

38. Eurozone performance The monetary policy of the ECB: • some criticism of relative lack of transparency of ECB as compared to Bank of England (not to Fed) • some concern re ‘excessive independence’ of ECB plus lack of accompanying political union • but on major issues consensus is that ECB is a good modern central bank making sound monetary policy decisions on basis of proper analysis and understanding • next few years: will it turn out that US and UK suffer from intensive liberalisation of 1980s-1990s, with excessive dependence on credit-based consumer spending, while Eurozone economy remains more stable and more robust to shocks?

39. Entry into the Eurozone All new members of EU are expected to enter EMU in due course, no choice Entry depends on fulfilment of Maastricht criteria: must • have no 'excessive deficit’ [defined with respect to reference values of 3% of GDP for deficit, 60% for debt] • keep inflation  average of 3 lowest in EU + 1.5% • keep long term interest rates  average of those in 3 lowest inflation countries + 2% • have observed 'normal' exchange rate margins in EMS for at least 2 years [interpreted to mean 15% margins] These criteria were originally set out as criteria for entry at start of EMU, and they are arguably less appropriate for new entrants now, but they are still applied

40. Entry into the Eurozone Entry into Eurozone now is not same as entry of first group of EMU members together in 1999 • basic mechanisms now exist, monetary policy is operating well, new currency is well established, monetary-financial system is relatively stable • so risk of entry is small compared to that in 1999 • and transactions costs of adopting euro are lower because e.g. Slovak firms already operate in euros

41. Entry into the Eurozone Growth effects of entry for country like Slovakia: • entry means fixing, permanently, its exchange rate against its major trading partners who are already fixed to each other, and using the euro over a much wider range of transactions, with consequent savings • evidence suggests monetary/currency unions promote trade (even if some estimates are ‘too high’), by reducing direct and indirect (transactions costs) barriers to trade • evidence suggests trade promotes economic growth • on the other hand, membership of monetary union means can’t depreciate exchange rate to compensate for higher domestic inflation causing loss of competitiveness

42. Entry into the Eurozone • overall, provided Slovak labour markets flexible enough to avoid loss of competitiveness, should expect strong positive growth impact from entry into EMU

43. Entry into the Eurozone Inflation effects of entry: • monetary policy of Eurozone is sound and stable, so in general would expect continued low inflation, but two reasons for thinking inflation may be higher: • first, introduction of euro notes and coin in January 2002 was accompanied by faster rises in some prices, mainly those for services sold in local, monopolistically competitive markets: from outside and on basis of statistical data effect looks small and temporary, but many in e.g. Italy, Germany, believe it was significant: it may be that new entrants have same experience when switch to euro notes and coin [evidence for Slovenia, Malta, Cyprus?]

44. Entry into the Eurozone • second, evidence suggests prices of internationally tradable goods are broadly comparable in different countries, but prices of labour-intensive non-tradable services and goods tend to be systematically lower in lower-income countries • as wages in lower-income countries rise towards those in higher-income countries, prices of those goods and services rise faster and converge towards those of higher-income • this means lower-income countries experience higher inflation: ‘Balassa-Samuelson’ effect, 1-2% p.a.?

45. Entry into the Eurozone