The European Monetary Union

Stanley W. Black University of North Carolina

References: http://en.wikipedia.org/wiki/Eurozone http://www.ecb.europa.eu/ http://ec.europa.eu/economy_finance/index_en.htm

The Long Road to The Road to the Treaty and the Euro • Customs Union and Common Agricultural Policy work better with a single currency • EMS kept currencies tied together, but under German leadership, 1979-1989 (11 members) • Multiple currencies of EMS pegged to D-mark inherently unstable, devaluations, speculation • With fall of Berlin Wall in 1989, needed 2007Slovenia joins 2008 and permission to reunify, wanted seat in

2009 2011 Monetary Policy decision-making • Compromise created the European Monetary Union under Maastricht Treaty

1 The Maastricht The Maastricht Treaty Convergence Criteria • A firm commitment to launch the single currency by • : January 1999 at the latest. – not to exceed by more than 1.5 per cent the • A list of five criteria for admission to the monetary union. average of the three lowest rates among EU countries. – Inflation, interest rates, exchange rates, fiscal deficit, • Long-term : debt/GDP ratio – not to exceed by more than 2 per cent the average • A precise specification of central banking institutions, interest rate in the three lowest inflation countries. modelled on the Bundesbank, independent of political • ERM membership: forces. – at least two years in ERM without being forced to devalue.

The Maastricht Interpretation of the Convergence Criteria Convergence Criteria: Inflation • Budget deficit: Straightforward 10.00 –deficit less than 3 per cent of GDP. fear of allowing • Public debt: in unrepentant – debt less than 60 per cent of GDP inflation-prone 5.00 • Criteria apply only for entry, not after! countries. • So Stability and Growth Pact agreed to cover post-entry behaviour – deficit and debt limits continue to apply, with 0.00 sanctions for violations 1991 1992 1993 1994 1995 1996 1997 1998

– But when Germany and France violated in 2003, no France penalties applied. Germany average of three lowest + 1.5%

2 Interpretation of the Budget The Debt and Deficit Criteria 120 Deficit and Debt Criteria in 1997 100 Maastricht fiscal criteria 1997 • Historically, all big inflation episodes born 80 out of runaway public deficits and debts.

• Hence requirement that house is put in ) 60

order before admission. 40 • How are the ceilings chosen?: Public Debt (%GDP 20 – deficit: the German golden rule: 3%

0 – debt: the 1991 EU average: 60%. -3 -2 -1 0 1 2 3 4 5 Deficit (% GDP)

The Most Serious Concern: The Deficit Bias The Deficit Bias The track record of EU countries is not good: • The track record of EU countries is not good. Public debts in 2009 (% of GDP) Public Debt/GDP 2009 EU public debt (% of GDP) 140

80 120

70 100

80 60

60 Public Debt/GDP 50

40 40

20

30 0

20 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006

3 The next wave of candidates Criteria for Entry were Fudged Quite different development levels (GDP per capita as % of EU)

Latvia • Germany wanted rigid adherence to rules Estonia Slovakia • But after German Unification, East Germany Malta required huge subsidies, led to large German Portugal deficits Cyprus Greece Spain • Thus rules were relaxed and Belgium, Italy, Italy Germany Spain, Portugal admitted even though debts France exceeded Maastricht limits Belgium • Even Greece was admitted a year later Aus tria

40 60 80 100 120 140

The next wave of candidates The next wave of candidates The inflation criterion The budget and debt criteria

80 10 MTA Euro area 1 +.5% 70 SVK CY 8 60 HU HU 6 50 EST LAT SVK POL 40 4 SLO CZ CY 30

MA GDP) (% of debt Public 2 LIT CZ PO 20 LIT LAT

0 10 EST 0 -2 -1012345 2000 2001 2002 2003 2004 2005 Budget deficit (% of GDP)

4 Architecture of the monetary union • N countries with N National Central Banks (NCBs) that continue operating but with no monetary policy function. • A new central bank at the centre: the (ECB). • The European System of Central Banks (ESCB): the ECB and all EU NCBs (N=27). • The Eurosystem: the ECB and the NCBs of euro area member countries (N=17).

How Does the Eurosystem Objectives Operate? • Objectives: • The Maastricht Treaty’s Art. 105.1: ‘The primary objective is price stability. Given price – what is it trying to achieve? stability, the objectives are a high level of employment and sustainable and non- • Instruments: inflationary growth. – what are the means available? – fighting inflation is the absolute priority – supporting growth and employment comes • Strategy: next. – how is the system formulating its • Operationally, the ECB aims at maintaining actions? inflation rates below, but close to, 2% over the medium term.

5 Instruments of Monetary Policy EONIA & Co. • The channels of monetary policy: – longer run interest rates affect investment – credit availability affects lending – asset prices affect consumer behavior – affects exports • These are all beyond central bank control. • Instead it controls the very short-term interest rate: European Over Night Index Average (EONIA). • EONIA affects the channels through market expectations.

Interest Rates in the and Comparison With Other Strategies the US (interbank rates) • The US Fed: – legally required to achieve both price stability and a high level of employment – does not articulate an explicit strategy. • Inflation-targeting central banks (Czech Republic, Poland, Sweden, UK, etc.): – announce a target (e.g. 2.5 per cent in the UK), a margin (e.g. ±1%) and a horizon (2–3 years) – compare inflation forecast and target, and act accordingly.

Sources: ECB, Federal Reserve Bank of New York

6 The Record So Far in a Does One Size Fit All? Difficult Period • With a single monetary policy, individual • the 9/11/2001 attack on United States national economic conditions cannot be • oil shock in 2000 responded to. • September 2002 stock market crash • When asymmetric shocks affect different • Afghanistan & Iraq Wars countries, only fiscal responses can differ. • Monetary policy cannot allow for • Global Financial Crisis 2008 & differences among member countries. Recession • Bailouts of European Banks

Inflation: Missing the Euro Area, US, Japan, UK Objective, a Little

3.5

3

2.5

2

1.5

1

0.5

0 Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- 99 99 00 00 01 01 02 02 03 03 04 04 05 05

7 But No Seriously The Euro: Too Weak at First, Then Too Strong? Asymmetric Shocks

Inflation rates GDP growth rates 25 12

EU12 10 Mi n 20 8 Max 6

15 4

2

10 0

-2

5 -4 EU12 Min -6 Max 0 -8 1990 1992 1994 1996 1998 2000 2002 2004 1990 1992 1994 1996 1998 2000 2002 2004

Although inflation has not Relative labor costs and fully converged prices have diverged Cumulated inflation 1999-2005 14 12 10

8 6

4 2

0 -2 -4

-6 Italy Spain Ireland France Greece Finland Belgium Portugal Germany Netherlands

8 Divergent Inflation Rates The Greek • Failure to prevent divergent inflation rates • Greek debt/GDP ratio reached 113% and leads to differing real interest rates deficit/GDP ratio reached 12.7% in 2009. • Cheap real interest rates in peripheral • Foreign bondholders became doubtful that countries (Greece, Ireland, Portugal, Greece could continue to roll over its increasing debt, forced interest rates higher. Spain) led to real estate booms, busts • EU faced choice between Greek default and • Core countries’ banks lend large sums to bailout with tough conditions. periphery • IMF and EU agreed to lend Greece up to $146 billion over three years. • Financial crisis leads peripheral countries • Greece to increase sales taxes, reduce public to bail out their banks, go heavily into debt sector salaries, pensions, eliminate bonuses.

Greek Bailout by EMU & IMF Irish Crisis • Reckless lending by banks to commercial and • May 2010: Greece adopts €110bn program supported by the EU and IMF residential property developers based on low • Program aims to restore sustainable public finances and real interest rates recover lost competitiveness • Bad debt of banks causes problems for whole • Far-reaching structural reforms being adopted (e.g. economy, government bailout landmark pension reform) • Deep recession – 14% unemployment • Drastic cuts in public expenditure across all levels of government • November 2010: Ireland adopts €85bn program • Program should stabilize debt ratio (but at a high level) supported by the EU and IMF • Requires sharp cuts in wages, prices and costs, • Program aims to cut budget deficit and repair the unpopular with strong unions damage caused by the banking crisis • Falling GDP raises debt ratio even if debt falls

9 Portugal’s Problems • Slow growth and high inflation since 2000 • Balance of payments deficit financed by foreign borrowing • Banks with bad debts were given govt. bailout • Large foreign debts can’t be repaid • EU and IMF program to lend € 78 billion with program including cuts to govt. spending, wages, benefits, privatization, increased taxes

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