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Joining a Monetary Union: Europe’s Great Monetary Experiment

Joining a Monetary Union: Europe’s Great Monetary Experiment. Eduard Hochreiter Joint Vienna Institute Wilfrid Laurier University Thursday, September 27, 2007 3.00 p.m. Overview. Introduction A Look at History The Architecture of Maastricht incl Coordination of Macro Policies

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Joining a Monetary Union: Europe’s Great Monetary Experiment

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  1. Joining a Monetary Union: Europe’s Great Monetary Experiment Eduard Hochreiter Joint Vienna Institute Wilfrid Laurier University Thursday, September 27, 2007 3.00 p.m.

  2. Overview • Introduction • A Look at History • The Architecture of Maastricht incl Coordination of Macro Policies • Benefits and Costs of Joining a MU • Institutional Requirements for Joining EMU • Economic Issues Regarding The Adoption of the Euro • The Adoption of the Euro: The Case of Greece • Experiences with EMU • Some general conclusions

  3. Introduction • Exciting experiment • born out of will to prevent wars • nourished by market integration • entering adulthood with the introduction of the euro • complex political – institutional – economic interaction; European integration perspective  difference to other regions • lecture pinpoints important institutional & economic issues

  4. 2. European Integration –Europe’s Great Monetary Experiment – A Brief Look At History - 1 1950: European Payments Union (EPU) 1952: European Coal and Steel Community (ECSC) 1957: Treaty of Rome 1958: European Economic Community (EEC) + EURATOM 1960: European Free Trade Association (EFTA) 1970: „Werner Report“: Create EMU within a Decade 1972: „European Currency Snake“ 1979: European Monetary System (EMS) 1986: Single European Act 1990: Stage 1 of EMU 1992: Maastricht Treaty 1993: Single Market for „Four freedoms“ a reality

  5. 2. European Integration –Europe’s Great Monetary Experiment – A Brief Look At History - 2 1994: Stage Two of EMU; EMI (European Monetary Institute) 1995: Fixing of starting date of Stage Three of EMU; “Euro” 1997: Amsterdam Treaty - SGP 1998: ECB; decision on 11 initial EMU members 1999: Stage Three of EMU 2001: Greece: 12th Euro Area-member 2002: Issuance of euro coins and banknotes 2004: Ten new EU-MS, mainly from CEE 2007: BG + ROM join EU; Slovenia 13th Euro Area-member 2008: Cyprus and Malta:14th and 15th Euro Area-member 2009: Slovakia becomes the 16th Euro Area-member? Back

  6. Back Back Back

  7. 3. The Architecture of the Maastricht Model - 1 Historical uniqueness of EMU: National states formally give up sovereign monetary policy in peacetime and transfer it to a supranational, independent institution the ESCB. Maastricht Treaty (MT): Price stability as basic common public good of the EU. The MT enshrines the European “stability culture”.

  8. 3. The Architecture of the Maastricht Model - 2 • Amsterdam Treaty: SGP SGP clarifies and modifies EDP + establishes an early warning system by setting up yearly stability programs to be submitted by MS + defines medium term budgetary objective of “positions close to balance or in surplus + sets strict deadlines for the application of the EDP + invites the imposition of sanctions • Reform of the SGP 2005

  9. Reform of the SGP 2005-1- • 3% (for budget deficit) and 60% (for public debt) reference values remain unchanged. • “Preventive arm“ changes: + Medium term objective “close to balance or in surplus” (CTBOIS) zero to surplus broadened to – 1% (high growth low debt countries) to zero to surplus (low growth high debt) and CTBOIS now country-specific Implies: European Commission now more room for discretion and interpretation + More symmetric“consolidation in good times” + No EDP when G-deficit > 3%, if overshooting due to temporary factors and “remaining close to the reference value”  Long list of temporary deviations from MT objective (e.g.: structural reforms)

  10. Reform of the SGP 2005-2- • “Corrective arm” changes: + No triggering of EDP, if economic growth contracts by more than 2%. Broadened to" negative growth or a period of low growth” + Long list of exceptional circumstances, e.g.: cyclical position, R&D, financial contributions to foster international solidarity, the unification of Europe, etc. + Minimum fiscal adjustment 0.5% p.a., if not CTOBOIS + Extension of deadlines of EDP + Repeating of procedural steps possible + Extension of correction period 2 years (Portugal 3 years already!!) Back

  11. 3. The Architecture of the Maastricht Model - 3 Monetary Policy centralized at euro area level and oriented towards an area-wide objective: the maintenance of price stability (defined by the System itself). Fiscal Policy predominately remains in the national domain, subject to the Treaty constraint that national economic developments must not influence monetary conditions in the euro area in a negative way. GUIDING PRINCIPLES: • “sound public finances” [Art 4(3)]; economic policies a matter of common concern (Art. 99) • No bailout clause (Art. 103) • EDP (Art. 104) --- Maastricht Treaty • SGP (Council Regulations 1466/97, 1467/97 and Council Resolution 97/C236/01-02) --- Amsterdam Treaty

  12. 3. The Architecture of the Maastricht Model - 4 2 major issues: • Question: Are there sufficient incentives for sound fiscal policies in EMU AFTER the adoption of the euro? • What are “sound”, i.e. sustainable fiscal policies? • Fiscal rules and coordination among fiscal policies • Question: How to secure the consistency of (only loosely coordinated) national fiscal policies with the area-wide stability-oriented monetary policy. • Is there a case for ex ante coordination between fiscal and monetary policies?

  13. 3. The Architecture of the Maastricht Model:What are sound, i.e. sustainable fiscal policies? = change in government debt at time t g = government expenditure exclusive of interest payments t = government revenue except seigniorage = „net“ interest payments, i.e. difference between the nominal interest rate and nominal GDP growth = change in monetary base = seigniorage Back

  14. 3. The Architecture of the Maastricht Model - 5 • (ad 1): Potential conflicts among national fiscal policies. How to discipline fiscal policy? Do we need fiscal rules in EMU? • Problem 1: excessive deficits in one region spread over the union: incentive for governments to overspend (in SR)  externalization of fiscal excesses [smaller rise in interest rate]: FREE RIDING PROBLEM • Problem 2: if so, bailout? (in LR) to avoid bankruptcy  potential cost of bailout spread over the union [smaller rise in inflation]: MORAL HAZARD PROBLEM • HENCE: (binding) fiscal rules (of some kind, e.g. SGP) recommended on economic grounds to avoid lax fiscal policies.

  15. 3. The Architecture of the Maastricht Model - 6 Coordination of fiscal and monetary policies: • The economics debate: How are fiscal and monetary policies related? Monetary and fiscal policy are linked through the intertemporal budget constraint (expected sum of expenditure = exp. sum of revenues); in EMU seigniorage is exogenous for govt.; hence budget constraint must be met in LR to avoid bankruptcy.

  16. 3. The Architecture of the Maastricht Model - 7 • What does theory tell us regarding the benefit/need to ex ante coordinate fiscal and monetary policy? • In simple two-player game theoretic models it can be shown that policy coordination improves the policy outcome (move from non-cooperative to bargaining equilibrium raises welfare; reduction of spillover effects) • BUT: Who takes the lead in fiscal policy in EMU? Will all the other (fiscal) players fall in line? Are all players symmetrically informed? Is the economic model agreed? How sizeable are the welfare gains?  Many uncertainties!

  17. 3. The Architecture of the Maastricht Model - 8 • Is there a need for fiscal rules? + Static macro model: IS-LM are independent  NO + Neoclassical perspective: if Riccardian equiv. holds or, if not, financial markets are efficient (sovereign credit risk is reflected in risk premia)  NO + Dynamic macro model = Maastricht Model: UMA (Sargent-Wallace) turns into UFA (Winckler-Hochreiter-Brandner)  YES + Fiscal theory of the price level: in the case of a fiscal shock monetary policy, ultimately, must produce enough (inflation tax) revenue for the state to remain solvent (see formula above) = fiscal dominance  NO ALTERNATIVELY: reduce G or raise T to secure the LR solvency of the state (see formula above) = monetary dominance

  18. 3. The Architecture of the Maastricht Model - 9 Fiscal policy surveillance and coordination: • Multilateral surveillance of fiscal policies: European Commission • Coordination through ECOFIN = institutional flaw as ECOFIN decides on existence of ED, the measures to be taken and the sanctions levied! Central instrument of policy coordination: BEPGsunder the Mutual Surveillance Procedure (Art. 99)  comprises the guiding principles of economic policy making in a medium term perspective of 3 years for the EU, euro area and each MS. Back

  19. 4. Benefits and Costs of Joining a MU- 1 - Benefits: • Lower transaction costs (OCA)  trade effects (beyond that of fixed exchange rates) – Rose 2000, Glick & Rose 2001, Frankel & Rose 2002. • Other micro efficiency gains (no exchange rate risk; lower interest rate differential; deeper financial integration; seigniorage gain through international use of currency (€). • Higher business cycle sycronicity  endogeneity of OCA • More real growth and reduced output and inflation variability

  20. 4. Benefits and Costs of Joining a MU- 2 - Costs: • Loss of monetary policy instrument • Loss of seigniorage • Higher real exchange rate persistence • Cost of asymmetric shocks

  21. 4. Benefits and Costs of Joining a MU- 3 - • Assessment for Europe (Hochreiter et. al, 2002, Table 2). BENEFITS: • savings on transaction costs: (EC 1990: forex + interbank transactions: + 0.5% p.a.; R. Mendizábal 2006: + 0.69% p.a. max.) • other micro gains: all positive impact on growth; most: financial deepening  substantial growth effects: > + 0.5% p.a. • higher BC synchronization (Böwer and Guillemineau 2006; and lower volatility (EC 2007). • growth benefits beyond that of fixed exchange rates through single currency  „Rose Effect“, i.e. tripling of trade (Rose 2000), + 30 to + 90 % trade growth for Euro Area (Rose and Stanley 2005). • additional seigniorage through international use of currency  small

  22. 4. Benefits and Costs of Joining a MU- 4 - COSTS: • loss of autonomy for monetary policy: can also be a blessing (e.g., Greece; Hochreiter & Tavlas 2005); • asymmetric shocks: negligible for most EU members; but, possibly size-related (sticky domestic adjustment mechanisms). • (Net) Loss of seigniorage: negligible, if at all. Back

  23. 5. Institutional Requirements of The Adoption of the Euro:The Maastricht Convergence Criteria - 1 • EMU membership is part of the legal EU Treaty framework, the "Acquis communitaire". • Hence, with EU entry also EMU and ESCB membership, but “with a derogation” • Euro adoption a right AND a Treaty obligation (no opt-out clause) • precondition for euro adoption: fulfillment of Maastricht convergence criteria

  24. 5. Institutional Requirements of The Adoption of the Euro:The Maastricht Convergence Criteria - 2 • Inflation criterion: an (sustainable) inflation rate not more than 1 1/2% higher than those of the three best performing EU countries (EU 27!!) over the latest 12 months.  Does this make sense in EMU? • Fiscal convergence criteria: (a) a general government budget deficitof not more than 3 % of GDP, unless either the reference value was exceeded only temporarily or exceptionallyand remains close to the reference value, or the ratio has declined substantially and continuously andreached a level close to the reference value.  Too restrictive? not enough room for manoeuvre? Procyclical?

  25. Derivation of 3% deficit reference value: where d = level of debt bp = primary balance b = overall balance i = nominal interest rate r = real interest rate = rate of inflation ge = government expenditure g = real growth rate t = taxes Back

  26. 5. Institutional Requirements of The Adoption of the Euro –The Maastricht Convergence Criteria - 3 (b) a government debt ratio of not more than 60 % of GDP unless the ratio is approaching that level at a satisfactory pace.  not enough emphasis on level of debt? 3. Interest rate criterion: an average nominal long term interest rate that does not exceed by more than two percentage points that of the three best performing member states in terms of price stability.  not really controversial 4. Exchange rate criterion: participation in the Exchange Rate Mechanism (ERM II) of the European Monetary System (EMS) within the normal fluctuation margin without severe tensions for at least two years and without having requested a devaluation.  useless or even counterproductive?

  27. Accession Criteria - 1 Source: European Commission

  28. Accession Criteria - 2 Source: European Commission

  29. Accession Criteria - 3 Source: European Commission Back

  30. 6. Economic Issues Regarding The Adoption of the Euro -1 • Fast or slow? + If net gains large and costs falling over time  quick adoption + If benefits and costs balanced and benefits rise over time  take your time + All subject to fulfillment of Maastricht criteria!

  31. 6. Economic Issues Regarding The Adoption of the Euro - 2 • Some major issues: + (Prudent) Fiscal positions (e.g.: Hungary) + Inflation (-differentials)  Balassa- Samuelson effects (e.g.: Estonia, Lithuania) + Capital flows (Sudden stops and reversals) + Financial sector development

  32. 6. Economic Issues Regarding The Adoption of the Euro - 3 • Vulnerabilities + Capital account volatility (policy inconsistency, asymmetric shocks, exit date risks) + Credit booms + Economic booms • Possible strategies to minimize risks up to the € + reduce fiscal deficits, contain inflationary pressures and maintain growth (structural adjustment)

  33. 6. Economic Issues Regarding The Adoption of the Euro - 4 • Entry into &Time spent in ERM II New EMS can join ERM II any time after EU accession. “training room” - or “waiting room” approaches • Strategies: + Adopt Euro as soon as possible and in ERM II as late as necessary (i.e. > 2 years before + Participate in ERM II as soon as possble and then take time to prepare for Euro adoption + „Wait and See“ approach • Risks of (untimely) ERM II entry: + Risk for too tight a corset + Risk for too loose a corset + Risk of speculative attacks Back

  34. 7. The Adoption of the Euro: The Case of Greece - 1 • Greece: EU 1981, at the time an EME at best (low income, high volatility, underdeveloped financial markets, etc.), highly regulated, capital controls, quite closed economy, political business cycles, structural rigidities. • Until mid-1990s inconsistent policies, fiscal dominance, futile search for nominal anchors (independent monetary policy an asset?), speculative attacks, currency crises, current account driven balance of payments crises; wage excesses, huge, persistent disequilibria, key economic indicators 1981 – 1995: • average inflation rate ~ 20 % p.a., • average budget deficit ~ 10% p.a., • public debt from <20% to ~ 120% of GDP • average real growth ~1 % p.a.

  35. 7. The Adoption of the Euro: The Case of Greece - 2 • 1995: Fundamental political decision to pursue policies that will allow Greece to introduce the euro in 2001  fundamental, sustained policy shift, anchored at Maastricht: • stability-oriented monetary policy: (pre-announced) “hard currency peg”), • fiscal consolidation, • tight prudential regulation and supervision of banks, • structural adjustment (privatization, wage bargaining processes, deregulation, financial market liberalization). • 1998: ERM entry AFTER policies set and intended euro adoption date (2001) credible! • Strong political will, broad political support, and adequate economic policies DECISIVE

  36. 7. The Adoption of the Euro: The Case of Greece - 3 • ERM entry (March 1998) with a devaluation • Thereafter: significant Drachma appreciation with some volatility; but very smooth exchange rate development as of spring 1999! • Credibility of maintaining adequate policies • Credibility of endpoint/exit! (+ conversion rate)

  37. 7. The Adoption of the Euro: The Case of Greece - 4 • Svensson test for Greece Back

  38. 7. The Adoption of the Euro: The Case of Greece - 5 • March 16, 1998: Central rate: ECU/EUR 1 = GRD 353.109 • January 17, 2000: New CR = GRD 340. 75 = Conversion rate Back

  39. 7. The Adoption of the Euro: The Case of Greece - 6 • What about (independent) use of monetary policy in the run-up to the euro? + Recall Impossible Trinity: fixed exchange rates and open capital account  no monetary independence! • But, Greece: • Use of tight monetary policy to reach inflation criterion until late 2000. • High real interest rates did cause significant capital inflows; sterilizing interventions bought time at the cost of come 0.5% of GDP.

  40. The Impossible Trinity Free Capital Movements Let exchange rate float to maintain monetary independence Use monetary policy to maintain exchange rate peg Independent Monetary Policy Pegged Exchange Rate Capital controls Back

  41. 7. The Adoption of the Euro: The Case of Greece - 7 Back

  42. 7. The Adoption of the Euro: The Case of Greece - 8 • Conclusions on Greek experiences: EMU provides the special circumstances to make the middle to be stable. • Only enter ERM II once convergence policies are CREDIBLY enacted and on track. • Importance of credible exit date and common view on conversion rate Back

  43. 8. Experiences with EMU- 1 - • Positive results • How to deal with heterogeneity in EMU? + Growth divergence  working of adjustment mechanisms + Inflation divergence  matter for concern or a normal phenomenon?  endogeneity of OCA criteria (labor mobility, fiscal transfers) Back

  44. 8. Experiences with EMU: Growth convergence- 2 - Back

  45. 8. Experiences with EMU- 3 - Back

  46. 9. Some General Conclusions - 1 • EMU is a unique experiment combining a supranational monetary policy with still national, albeit loosely coordinated, fiscal policies. • EMU has a very important political dimension.  Sets it aside from other regions thinking about a MU. • Policy coordination in EMU and EU mostly is about coordination among fiscal policies and between fiscal and other economic policies and NOT between fiscal and monetary policies.

  47. 9. Some General Conclusions - 2 • The Maastricht Treaty stipulates that in case of inconsistencies between fiscal and monetary policy the former has to yield to the latter: the Maastricht framework is one of monetary dominance as opposed to fiscal dominance. • The Treaty does not foresee ex ante co-ordination between fiscal and monetary policies. • Greece offers some useful insights for EU countries that as yet have not adopted the Euro.

  48. THE END THANK YOU FOR YOUR ATTENTION!

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