Lecture 10

1. Lecture 10 International Finance ECON 243 – Summer I, 2005 Prof. Steve Cunningham

2. Optimum Currency Area (OCA) • The economic theory examining the necessary and desirable characteristics of countries economies for membership in a monetary union is the theory of the optimum currency area (OCA). • The theory was introduced and popularized by Robert Mundell (1961), Ronald McKinnon (1963), and Peter Kenen (1969). • Robert Mundell received the Nobel Price in Economics in 2000, in part for his contribution to OCA.

3. Costs and Benefits • Key question: Is the economy of the candidate country characterized by relatively stable or rising prices and wages? • The formation of a monetary union results in the loss of monetary and exchange rate policies. • The loss of these policies is considered to be the most important cost in joining a monetary union. • These are the most useful policies to a country experiencing internal shocks. These policies are used to fight recession or inflation. • Robert Mundell’s initial contribution on the OCA was developed within the IS-LM-FE model which assumes constant prices. Rising prices can neutralize some or all of the positive effects of these two policies.

4. Are the shocks symmetric? • An exchange rate policy can be used by a non-member country to fight its way out of recession caused by an asymmetric shock. • So it is important to study the nature and expected frequency of asymmetric shocks for members of EU countries. • If most of the shocks are symmetric, then member countries can use policy related to the common currency to jointly deal with the shock. • Asymmetric shocks can arise from differing financial, legal, and tax systems, and structural differences in labor markets and institutions. Of course natural disasters within a limited geographic region are another cause of such shocks.

5. Integration and Shocks • Increased intra-industry trade and further economic integration should reduce country differences which cause asymmetric shocks. • Empirical evidence suggests that business cycles in EU countries became more synchronized after the 1980s. Not all economists agree with this evidence. • Paul Krugman (1993), drawing on U.S. evidence, argues that economic integration leads to regional concentration of industries. (e.g., automobile plants in Michigan) • Obviously, regional concentration of industries could lead to asymmetric shocks.

6. Seigniorage • This is another potential cost to a monetary union—the loss of the ability of the governments involved to raise revenues through inflationary finance. • Seigniorage is essentially an “undeclared tax” on money balances held by people and businesses. • When gov’t print too much money and cause inflation, the money already being held by the public loses value (purchasing power). • This loss of value is almost equal to the value of the newly printed money. This is seigniorage.

7. Seigniorage (2) • Generally speaking, most gov’ts relied heavily on seigniorage prior to WWII. Since then, most industrialized countries have developed elaborate tax systems to raise revenues. They have not had to rely as heavily on seigniorage. • Southern EU countries consistently depended on seigniorage for revenue, and have less well-developed tax systems, and tend to inflate more readily. • This has caused some researchers to argue that Southern European countries should remain outside the monetary union. • Other researchers disagree strongly, saying that the monetary discipline of the union would be a major benefit to these countries.

8. Overall Cost Considerations • Expected costs of the formation of a monetary union will be lower if labor markets are flexible and if free labor mobility is high. • Regional unemployment can be offset by labor moving to another region, and would not require direct policy intervention. • The expected costs of union would also be lower if the budgetary process is centralized, and the monetary union is vested with fiscal powers (i.e., a budget). • This would allow the union to direct loans or aid to countries or regions suffering asymmetric shocks.

9. Benefits • The most frequently mention benefits arise from the elimination of transactions costs. • These occur when businesses and consumers must exchange currencies to purchase goods and services. • They occur when businesses invest abroad. • They occur when financial investors purchase foreign securities. • Whether the reduction of such costs (risks) actually increases the volume of trade is uncertain. • Ironically, while some firms may benefit the reduction of such costs, it directly reduces the income of banks and other financial institutions who sell services to deal with exchange rate problems!

10. Benefits (2) • Price transparency • Expressing all prices within the union in terms of only one currency allows everyone to compare prices more easily. • Consumers discriminate better on price, and firms become more competitive. Both factors are anti-inflationary. • Foreign Reserves • Member countries do not have to hold reserves of other member countries’ currencies.

11. Benefits (3) • If the monetary union is a large, successful, and stable economic entity, then its currency is likely to become an international medium of exchange—a dominant currency. • This makes it easier and cheaper for the union to sell its debt in foreign markets. • Foreign banks will hold its currency in reserve. • The union may also contribute to price stability for its members, encouraging long-term commitment of resources by the public, and providing clearer economic signals to market participants.

12. Is the EU an OCA? • An OCA, according to theory: • Must consist of only economically integrated countries. This ensures that shocks are symmetric. • Economic integration leads to the formation of a flexible common market for all factors of production and products—another requirement. • The central authority of the monetary union must have significant fiscal powers to be able to deal with remaining asymmetric shocks.

13. Is the EU an OCA? (2) • The Single European Act (SEA) which became effective in 1993 contributed to the integration of many aspects of the EU countries. • The idea was to create a Single European Market (SEM) without frontiers or barriers. • Differences still exist in: • The legal, taxation, and financial systems. • The organization and flexibility of labor markets, • Economic growth rates, and • Unemployment rates.

14. Is the EU an OCA? (3) • (EU, EU15, EU25) • Biggest differences are between the Northern and Central European countries and the Southern Mediterranean countries. • The northern/central region includes the more developed industrial countries, while the southern region includes more agriculture-based employment. • This became an issue again with the May 2004 expansion to the EU to include 10 new member countries.

15. Is the EU an OCA? (4) • Bayoumi and Eichengreen (1994) estimated and compared permanent supply shocks among 8 U.S. regions and among 11 EU countries. • Permanent supply shocks were not correlated across the EU countries, whereas the U.S. regional supply shocks were highly correlated. • Supply shocks in the EU were also larger than those in the U.S. regions. • They concluded that the 11 EU countries did not constitute an OCA. • They argued that a smaller core of EU countries comprised of Germany, France, Belgium, Netherlands, and Denmark form a more homogeneous group, and therefore more qualify as an OCA.

16. Is the EU an OCA? (5) • These authors recommended that this core group form a monetary union, and that other countries be added as they meet certain integration criteria. • A study by the EC Commission (1990) found that some costs of forming a monetary union had been exaggerated, shifting the cost-benefit ratio in favor more inclusive membership. • The loss of exchange rate policy was not as critical as some had estimated previously. • Exchange rate policies against one another tends to allow one to gain at the expense of the other. As a result, such policies tend to be met with reprisals, thus reducing the benefits of such policy. • Also, such policies depend on prices being stable, so that real exchange rates actually change.

17. External Benefits of Integration • The joint/total reduction of transactions costs among member nations has been estimated at about 1% of their joint GDP. • Each country joining the EMU also generates external benefits. • As more countries join, the benefits of monetary integration also increase. • One problem with applying this to the EMU is that the EMU lacks substantial budget power. • This makes it impossible for the the central authority to compensate (through redistribution) member countries for external benefits or individual costs.

18. External Benefits of Integration (2) • It has become clear that the countries that benefited most from the EMU are those that “imported price stability” by adopting the common currency, avoiding local political pressures to inflate their currencies. • These are primarily Greece, Spain, Portugal, Italy, and Ireland.

19. Labor Markets in the EU • Labor markets in Europe are rigid. • They have low mobility. Many European workers are unwilling to relocate to seek employment within their own country, let alone to other countries. This is attributed to: • Cultural barriers • Language • Climatic problems • They have high wage rigidity. EU labor markets have strict labor laws and labor organizations which are responsible for such wage rigidity. • Most economists are convinced that labor market rigidity is one of the most important causes of high unemployment rates in EU countries.

20. Labor Markets in the EU (2) • One problem is the heavy centralization of trade unions and employers associations that often negotiate labor agreements at the national or regional levels. • This allows for little variation of wages to account for differences in labor productivity among companies. • Small companies often cannot afford to pay such wages when their levels of automation and volumes do not permit the high productivity rates needed to support high wages. • Economic theory suggests that firms optimize when they pay labor its marginal product.

21. Labor Markets in the EU (3) • Since the late 1990s, many policies were adopted in almost every EU state to introduce more flexibility with labor markets. • Incentives were offered to firms to increase hiring and to unemployed workers to seek jobs more aggressively. • Employment levels have improved, but many of the gains have been through temporary, contract, and part-time employment. • From 1996 to 2001, employment in the Euro Area increased by 1.6% per year. (U.S. employment increased by 1.3% per year, even though its economy grew more quickly.)

22. A Success Story • Ireland was a slow-growth, low income country not so long ago. • By 2001, Ireland had the 2nd highest per capita income in the EU ($28,500). • Ireland also has the lowest corporate tax rate in the EU at 12.5%.

23. The Lisbon Agenda • During the March 2000 EU Summit in Lisbon, Portugal, the members agreed to transform the EU by 2010 into the most dynamic, knowledge-based, competitive economy in the world. • The countries agreed to pursue economic, social, and environmental policies that would lead to sustained development, high economic growth, and social cohesion. • They will pursue structural reforms by investing in R&D and innovation, and by completing the SEM. • The idea is to make the EU more of a OCA.

24. The Lisbon Agenda (2) • Among the changes introduced in the individual countries, have been the reforms called for by firms: • To reduce long-term unemployment benefits, • To Reduce pension payments, • To have more freedom in laying off workers, and • To have more freedom in increasing working hours per week. • Not surprisingly, many EU workers and trade unions saw these proposals as challenges to workers’ rights and benefits, and an adoption of U.S. practices. • Many governments accepted in principle the Lisbon Agenda as a necessary program to help the EU economist recover from slow growth and unemployment.

25. Example: France • Nicholas Sarkozy, a French politician, asked Michel Camdessus, a former head of the IMF for an explanation of the causes of the French economic slowdown, and asked for recommendation to reinvigorate the French economy. • Camdessus with a 20-member team published a 140-page report in 2004. • He argued that the problem was a failure to respond to challenges related to: • The diffusion of new technologies and training • An aging population • Globalization

26. Example: France (2) • Recommendations: • Liberalize the labor market, • Reduce public debt, and • Get the universities and companies to work together to promote the necessary knowledge base among the workforce. • He argued that similar reforms were working in: • Sweden (which restructured its labor markets and state pensions) • Finland (which attained a high-level knowledge economy) • Denmark (which reformed its welfare state) • UK (which liberalized its labor market)

27. Example: France (3) • Camdessus found that for many years GDP growth for the U.S. exceeded that of France and other EU countries, and the U.S. unemployment rates were lower. • At the same time, labor productivity in the U.S is about the same time as in France. • The direct implication is that the problem if France and the EU in catching up to the U.S. is not competitiveness of its industries. • European workers, by choice, work 20% fewer hours than U.S. workers.

28. Example: Sweden • Introduced substantial labor market flexibility that has increased manufacturing sector labor productivity. • Unfortunately, Sweden did not increase labor productivity in the services sector as in the U.S. • Wages are no longer set at the national level. Sectoral labor contracts are flexible. • The pension system was reformed: • Pension income is determined according to real wages, longevity of the retiree, and the growth of the economy. This ensures the integrity of the system.

29. The Future of the Lisbon Agenda • According to a 2004 EC Commission report, the following areas are key to achieving the goals of the Lisbon Agenda: • Investment in networks and knowledge. • Strengthening competitiveness in industry and services through the completion of the internal market. • Increased labor participation of older people by encouraging older workers to delay retirement. • After reviewing the Commission report, in March, 2004, the EU leaders pledged to accelerate the pace of the reforms. • The Dutch prime minister, Wim Kok, was chosen to head a group to study the progress. The Kok Report of November 2004 focused on the lack of political commitment of the EU member states to the objectives.

30. Comparative Statistics, 1999-2003

31. Euro Timeline • 1957: The Treaty of Rome was signed, establishing the EEC and EUROTOM. • 1958: The Monetary Committee was formed as an advisory body to the ECOFIN. • 1964: The Committee of Central Bank Governors was formed. • 1970: The Final report of the Werner plan is completed. (Feasibility of a European Monetary System)

32. Euro Timeline (2) • 1979: The EMS became effective. The EMS consisted of three components: • Exchange Rate Mechanism (ERM) • European Currency Unit (ECU) • European Monetary Cooperation Fund (EMCF) • 1989: The Delors Report is published. (Recommends three stages for deployment of a full monetary union for the EC) • 1991: The Maastricht Treaty was approved by the heads of the EC states in 1991, signed in Maastricht in 1992, and comes into force in 1993.

33. Euro Timeline (3) • 1999: The EMU is launched in 11 EU countries. • 2002: Euro notes and coins are distributed in 12 European countries. On March 1, 2002, the euro is the sole legal tender in 12 Euro Area countries.

34. The Eurosystem • Monetary policy in the Euro Area is entrusted to the Eurosystem. This consists of: • The European Central Bank (ECB) • 12 National Central Banks (NCBs) • The organization is remarkably similar to the U.S. Federal Reserve System, although the number of NCBs is only coincidentially the same as the district banks in the U.S. system. • There will be an NCB for each country that joins. • Along with the General Council, an advisory body to the ECB, and the NCBs of non-euro countries, this constitutes the European System of Central Banks (ESCB).

35. European System of Central Banks EUROSYSTEM Formulatesmonetary policy GOVERNING COUNCIL(Decision-making Body) Executive BoardPresident 1Vice President 1Members 4 6 Governors of NCBs12 Total 18 EUROPEAN CENTRAL BANK (ECB)Frankfort, Germany National Central Banks implement monetary policy in the Euro Area … NCB12 NCB1 NCB2 advise National Central Banks that have not adopted the euro GENERAL COUNCIL(Advisory Body) President 1Vice President 1Governors of NCBs of all countries 25 Total 27 … NCB24 NCB25 NCB13

36. Eurosytem • Note that the distinction between the Eurosystem and the ECSB will continue until all EU member countries join the EMU and adopt the euro. • At that time, the system will simply be the ECSB.

37. The Governing Council • The Governing Council formulates the monetary policy of the Euro Area. • The Maastricht Treaty requires the Governing Council to convene at least 10 times per year, but it usually meets twice a month in the Eurotower in Frankfurt, Germany. • It has three (3) major functions: • Provide price stability, • Provide liquidity to the entire Euro Area banking and financial system, and • Establish and maintain an efficient payments mechanism throughout the EU.

38. The Governing Council (2) • To do this, the Governing Council controls bank reserves, sets certain key interest rates, and ultimately attempts to control the money supply in the Euro area. • The first president was Willem Duisenberg, previous the governor of the Dutch Central Bank. • The second president is Jean-Claude Trichet, previously president of the French Central Bank. • Both presidents are known for their strong stance on price stability in their countries.

39. The Executive Board • Executive Board members serve 8-year, nonrenewable, staggered appointments. It is hoped that this will provide continuity of experiences members on the Board. • The Executive Board is responsible for implementing monetary policy on a daily basis. The Executive Board instructs the NCBs to conduct certain policies. • The idea is that the NCBs are closer to their local money and financial markets, and therefore are better able to implement policy. Geographic distance was one reason given. (Like US FRBs?)

40. The General Council • To coordinate actions between euro and non-euro EU countries, the General Council was created. • The General Council inherited the responsibilities of the previous European Monetary Institute (EMI) which was dissolved with the creation of the ECB.

41. Objectives • The primary objective of the ECB is the pursuit of price stability for the entire Euro Area, as stated in Article 105 of the Treaty which established the EC. • In order to do this, the ECB was granted political independence from other EU institutions and national governments. As of today, the ECB is considered the most independent central bank in the world. (It was modeled after the Bundesbank of Germany. • It is prohibited from financing government deficits. • It is institutionally and financially independent from EU institutions by having its own budget. (It is financed by the NCBs and not the EU budget.