The Challenge of Enlargement of Euroland

1. The Challenge of Enlargementof Euroland Paul De Grauwe University of Leuven

2. The launch of the euro has been an extraordinarily successful operation • Yet there are challenges ahead • The main challenge comes from the enlargement

3. Several issues • Is a Eurozone of 25 countries an OCA? • How will enlargement affect costs and benefits of EMU for the present members? • Can an enlarged Eurozone continue to function as it does today?

4. 1.Is a Eurozone of 25 countries an OCA?

5. The traditional theory • Definition of OCA • According to traditional theory of OCAs, the optimality of currency areas depends on three variables • Openness (integration) • Asymmetry of shocks • Flexibility

6. Costs and benefits monetary union:asymmetry and flexibility asymmetry • In OCA-zone: • benefits of EMU exceed costs • Asymmetry of shocks is compensated by flexibility • Outside OCA-zone • Reverse holds OCAI OCA-zone flexibility

7. Nature of OCA-zone: • benefits of EMU exceed costs • countries find the cost of not being able to use their national monetary policies to deal with asymmetric shocks small compared to the benefits of the union. • Union central bank is not perceived to neglect national monetary conditions when setting unique interest rate. • Monetary policy that fits one size is not perceived to be costly.

8. Costs and benefits monetary union:asymmetry and openness asymmetry • In OCA-zone: • benefits of EMU exceed costs • Asymmetry of shocks is compensated by opennes (integration) • Outside OCA-zone • Reverse holds OCAII OCA-zone Openness (integration)

9. Evidence: Openness

10. Evidence: Asymmetry of shocks

11. Central European countries are relatively open to rest of EU • More so than the UK • Central European countries subject to more asymmetric shocks • This is also the case for UK • Missing links: • Flexibility: we know very little about this

12. Is EU-25 an OCA?asymmetry and openness asymmetry • EU-25 is likely to be outside OCA-zone • There is a large component of uncertainty • Endogenous nature of dynamics towards OCA: OCA-criteria could be selffulfilling OCAII EU-25 OCA-zone opennes

13. Complicating factor: • Many countries see monetary union as instrument to import monetary stability • Cfr. Southern European countries prior to EMU • Central European countries today • As a result traditional OCA-analysis plays little role in decision to join • Once monetary stability is achieved traditional OCA-analysis will reappear with a vengeance

14. 2. Implications of enlargement for present eurozone

15. Implications of enlargement for present eurozone divergence • EU-25 less integrated and more subject to asymmetric shocks than EU-12 • original members of Euroland (who are also part of EU-25) have to wait longer to reach OCA-zone • Some original members will perceive policies of the ECB to be less receptive to shocks than before the enlargement OCA EU-25 EU-12 openness (integration)

16. perceived costs of the union will increase relative to the perceived benefits of the single currency. • tensions inside the Eurosystem increase when some countries feel that their economic interests are not served well by the ECB.

17. ECB can do very little about this • Nevertheless it is likely to get part of the blame • Greater acceptance that the ECB cannot deal with national problems

18. Intermezzo:Should UK join EMU? • Openness: UK relatively little openness • Asymmetric shocks are relatively large • Flexibility

20. UK is relatively closed towards EU • UK experiences relatively large asymmetric shocks • BUT, UK has more labour market flexibility allowing it to better adjust to these shocks • Benefits may be higher than costs • Cost-benefit calculus for member countries may deteriorate

21. 3. Enlargement and institutional reform

23. present system: equal representation of each member country in the Governing Council • such a system works satisfactorily today. • will it work well when Eurozone has 25 countries?

24. Present situation: a lot of asymmetric shocks

25. Asymmetric developments of inflation and output growth create different desires about the interest rate that should apply for Eurozone • We can measure these desires by the Taylor rule

26. Taylor rule rt = a + bt + cxt rt = nominal interest rate t = inflation xt = output gap

27. Present situation: asymmetric distibution of desired interest rates using Taylor Rule (2002) Assumptions: Governors are nationalistic ECB-board cares about Euro-wide interests Conclusion ECB-Board has strategic position despite asymmetries in shocks

28. Conclusion of previous analysis • Today the ECB-Board has strategic position within Governing Council. (Its interest rate proposal is close to median) • This is maintained even when distribution of desired interest rates is very different among large and small countries. • This decision making process ensures that the interest rate that is decided is the optimal one from the point of view of the Eurozone as a whole.

29. This is so even if national governors are guided by economic conditionsprevailing in their own countries. • This decision making model also ensures that large countries’(France, Germany, Italy) interests are relatively well served, despite the overrepresentation of the small countries in the Governing Council. • Consensus is easy to reach and formal voting usually unnecessary

30. After enlargement: asymmetric distibution of desired interest rates

31. In enlarged Eurozone the ECB-Board will loose its strategic position. • Its interest rate proposals will occasionally be overruled by coalitions of small countries who experience different economic conditions than the average (which is dominated by the large countries). • Interest rate decisions will be made on the basis of economic conditions that prevail in a relatively small part of Euroland.

32. This will lead to grave conflicts within the Eurosystem. • Consensus model is likely to break down. • The essence of the problem: small countries are over-represented in the Governing Council • in enlarged Eurosystem this will have fatal effect that interest rate decisions may not always be made on the basis of the average economic conditions that prevail in the union.

33. How to solve this problem? • The importance of small countries in the Governing Council must be reduced • so that the strategic position of the Board can be maintained. • Several possible formulas

34. Possible formulas • US Fed formula: all governors participate in deliberations of Governing Council but voting rights are restricted to a limited number of governors (e.g. ten) on a rotating basis. • The IMF formula: small countries group together in constituencies and are represented by one governor. • The centralisation formula: the decision making is centralised in the Executive Board of the ECB. In this formula there is scope for expanding the size of the Board. • ECB-proposal is mix of formula 1 and 2

35. Conclusion • It is unlikely that a Eurozone of 25 members is an OCA today • It may become one in the future • Many countries want to join so as to achieve monetary stability. This may not be a good motivation. • Enlargement is likely to make the Eurozone less attractive for present members • Enlargement will require important institutional changes within the Eurozone.