Sweden and the Uk Have Chosen Not to Join the Monetary Union

SNS ECONOMIC POLICY GROUP REPORT

en years have passed since the start of the monetary SNS FÖRLAG union. The 2009 report of the Economic Policy Harry Flam (chairman) Group analyses the economic record of the Antonio Fatás T Steinar Holden countries that joined at the start and how it has been affected Tullio Jappelli by the common currency and the common monetary policy. Ilian Mihov The areas covered are monetary policy, ﬁscal policy, Marco Pagano ﬁnancial integration, foreign trade and foreign direct Charles Wyplosz investment. Denmark, Sweden and the uk have chosen not to join the monetary union. The report also compares their economic record to that of the euro countries, and assesses SNS ECONOMIC POLICY GROUP if the record would have been different had the three outsiders joined the monetary union from the start.

The authors are professors Harry Flam (chairman), Antonio Fatás, Steinar Holden, Tullio Jappelli, Ilian Mihov, Marco Pagano and Charles Wyplosz. 2009

REPORT EMU AT TEN

2009 SHOULD DENMARK, SWEDEN AND THE UK JOIN? ISBN 978-91-85695-96-6 EMU at ten sns economic policy group report

EMU at ten. should Denmark, Sweden and the uk join? 2009

Harry Flam (chairman) Antonio Fatás Steinar Holden Tullio Jappelli Ilian Mihov Marco Pagano Charles Wyplosz

SNS Förlag sns Förlag Box 5629 se-114 86 Stockholm Phone: +46 8 507 025 00 Fax: +46 8 507 025 25 [email protected] www.sns.se sns – Centre for Business and Policy Studies – is an independent network of leading decision-makers from the private and public sectors who share a commitment to social and economic development in Sweden. Its aim is to improve the basis for rational decisions on major social and economic issues, by promoting social science research and stimulating public debate. sns Economic Policy Group Report 2009 emu at Ten Should Denmark, Sweden and the uk join?

Foreword 7

1 Introduction and summary 9 2 Monetary policy 18 3 Fiscal policy 40 4 Financial integration 58 5 Trade and investment 76 6 The three outsiders and the monetary union 95

Authors 121

( 5 ) ( 6 ) 6 ( sns, Studieförbundet Näringsliv och Samhälle (Centre for Business 7 and Policy Studies), is an independent, non-partisan network of leading decision-makers in the private and public sectors. sns commissions and carries out research, publishes reports and books and ar- ranges seminars and conferences with a view to inform and stimulate public discussion and rational policy-making relating to economic and social issues. The sns Economic Policy Group (sns Konjunkturråd) consists of independent scholars who, at the request of sns, present theoretical and empirical findings relating to current economic policy issues. The Group’s annual reports seek to stimulate constructive and fact-based discussions on economic policy. Ten years ago the euro, the common currency of the European Un- ion, was introduced. The sns Economic Policy Group Report 2009 analyses the performance of the economic and monetary union for its member countries as well as for the outsiders. The report deals with monetary policy, fiscal policy, financial integration, trade and foreign O RD direct investment and whether the economic performance of the outsiders Denmark, Sweden and the United Kingdom would have been different if they had participated from the start. O REW F Professor Harry Flam, the Institute for International Economic Studies, Stockholm University, is the chairman of the sns Economic Policy Group 2009. The other members are professor Antonio Fatás, insead, Paris; professor Steinar Holden, Oslo University; professor Tullio Jappelli, University of Naples; professor Ilian Mihov, insead, Paris; professor Marco Pagano, University of Naples and professor Charles Wyplosz, the Graduate Institute of International Studies, Geneva. Financial support from the Jan Wallander and Tom Hedelius Foundation and the Tore Browaldh Foundation is gratefully acknowledged. sns also thanks those who have commented on drafts or otherwise contributed to the report. The Economic Policy Group has enjoyed full academic freedom. As is the case for all sns publications, the authors bear sole responsibility for the contents. stefan lundgren, ceo and president, sns

( 7 )

chapter 1

i n t r o d u c t i o n and summary

he eu monetary union celebrated its tenth anniversary at the beginning of 2009. An assessment of its performance is of interest not only to its members but also to those eu countries that are outside, and in particular to Denmark, Sweden and the United Kingdom – countries that could join but have chosen not to. This report will • assess the performance of the monetary union, • propose improvements, and • assess whether the three outsiders should join.

The monetary union involves replacing the national currencies by one currency common to them all, and replacing the former national monetary policies by a common, supranational monetary policy carried out by the Eurosystem, the European Central Bank (ecb) and the national central banks of the euro countries.1 The loss of mon-

1. The Governing Council of the ecb decides on and the national central banks implement the monetary policy.

( 9 ) 10 chapter 1 Throughout its lifetime, the what the outcome will be. The constitute a severe test for the monetary union, and it is as yet unclear relative economic stability. The financial crisis and its repercussions marked by what has been called The Great Moderation, a period of at the end of the ten years with the euro, most of the period has been Although the financial crisis has severely affected the world period. economy euro whole the studies report the that crisis financial going It must be stressed at a time when the interest is focussed on the on- establishment of the Inner Market in the for the stabilization of exchange rates in the the in tariffs of elimination the as measures Europe«. of ing the ultimate goal, namely »… an ever closer union of the peoples nomic issues, the other central banks. seems to have been faster in taking in the importance of the crisis than trade • financial • fiscal • monetary • an independent central bank. both adopted a monetary policy with an inflation target carried out by effect giving up its monetary independence, while Sweden and the of the monetary union. Denmark pegged its currency to the euro, in borders. The three outsiders reacted differently to the establishment markets, trade in goods and services, and investment across national duction of a common currency was also expected to affect financial Fiscal policy became the main instrument for stabilization. The intro- stabilize the economy in the face of business cycles and other shocks. to ability governments’ affect to expected was independence etary whether • have been different had they participated from the start. It should also be stressed that while the report concentrates on eco- This report examines five issues: policy, and the integration, emu foreign policy, economic emu is the latest step in this direction, following such following direction, this in step latest the is direct is a political as much as an economic project. performance investment, eu ecb has used economic projects for achiev- 10 ) ( has performed very well so far and and of 1990s. the 1970s and s, various schemesvarious 1960s, three outsiders 1980s, and the would uk

The Monetary policy a • credibility • The extent to which this success depends on the rate as the euro area. to the euro, and has achieved the same (weighted) average inflation rate of inflation. Denmark has successfully linked the rate of the krone England, have been equally successful in achieving a low and stable of Bank the and SwedishRiksbank the them among banks, central stability of the world economy up to determine • are to be better managed. The if its longer-term expectations about the future course of the economy and its general transparency should be raised to the best-practice level etary policy strategy, its communication strategy, its decision-making publish • not • criteria should either Their catching-up process may take a generation or more. The entry euro. the against rates exchange fixed and inflation low of criteria inflation, making it practically impossible for them to meet the entry growth that tends – for structural reasons – to produce relatively high rapid and change structural of period a experiencing are states ber when they were adopted in prudence and sustainability in mind, and were already controversial The criteria for joining the currency union were designed with fiscal be • Although the and the monetary policy rate two or three years in advance, and tively low rate for a certain time before entry, as they do now, or states to join the monetary union. ecb low reinterpreted require has successfully achieved and the stable for and fixing minutes ecb its make rate in inflation the has been successful, it is important that its mon- such of of exchange public the inflation, a 1991. The economies of the new mem- way target meetings ecb 11 ) ( official as rate should thus (»below, to and 2007 is not entirely clear. Other make and of forecasts the keeping it but Governing easier ecb close for inflation or on the relative for output, to new 2 per cent«). Council. member inflation at a rela- 11 introduction and summary 12 chapter 1 Differences • broad • Some • The • when it comes to stabilizing the economy. The record is mixed: tional monetary policy puts more weight on discretionary fiscal policy to stabilize the economy or for other reasons. The abdication of a na- changes in revenues and expenditures undertaken by policy-makers of the business cycle, and discretionary fiscal policy, i.e. discretionary cyclical adjustment of public revenues and expenditures in the course Fiscal policy includes automatic stabilizers, i.e. the automatic counter- Fiscal policy Automatic • a • urgent need of fiscal policies are a sign of poor policy-making. Many countries are in countries (among them France, Italy and Germany) and procyclical Persistently area euro the of many in deficits and debts public large National • Denmark, • The • effect on the dynamics of public debt and deficit in the euro area. making, and since the early smaller much become have countries non-euro and euro both Denmark, Sweden and the ary fiscal policy and, consequently, to stabilize the economy. and Growth Pact have helped to reduce the volatility of discretion- terms of automatic stabilization. strongly procyclical and thus destabilizing. been has area euro the of stance policy fiscal overall the and cal more ceilings monetary euro political transparent discretionary Sweden stabilizers countries in on 1990s. the support union public business and and exhibit are does deficits fiscal for the well-defined fairly such uk. uk not cycle 12 ) ( policies similar are very similar to the euro area in and strong seem a framework. at debt debt a tend framework to and given have imposed and have to point have had deficit worked for by any been in fiscal dynamics the time significant well. procycli- Stability policy- across as Money • dictably led to the integration of financial markets: The replacement of national currencies by a single currency has pre- Financial integration a • ion has led to The elimination of nominal exchange rates within the monetary un- T Corporate • a • Improved • Equity • a • these measures in particular. The financial crisis has drawn attention to the need for the last two of The • no • Sharing • Greater • tion: integra- further promote to measures several proposes report The Supranational • Uniform • rade and foreign direct investment from countries outside it. with the same cash flow. instruments for same the practically are rates the i.e. area, euro transactions data. and cial institutions. more substantial integration. different clearing and settlement systems represent barriers to any area and countries outside it, interest rate differentials. persistent exhibit all market mortgage the and market credit er substantial possible smaller certain medium markets and transparency information deposit but effects increase enforcement bond government increase and still regulation have markets on guarantees. long-term substantial in foreign about become in foreign in of trade the bond are and loan loan direct corporate corporate 13 ) ( very direct within increase somewhat supervision markets contracts applicants investment integrated. investment the credit bond in are euro more in trade between of many fully market markets, within area, transnational integrated, between into integrated countries. by countries. the the the publishing euro euro consum- the but finan- in area, euro area the the 13 introduction and summary 14 chapter 1 • tive to these in the euro area can be summarized as follows: growth. long-run on effect no or little have should regime policy monetary roughly the same in terms of an unweighted average. However, the since countries outsider three the in higher been has growth Economic the UK had joined in 1999? What if Denmark, the remaining trade barriers would lead to further increases in trade. for services. A fuller implementation of the rules and perfectly the implementedelimination andof trade barriers remain in important Market – markets free movement of goods, services, capital and labor – are im- ices complement each other. The rules underlying the Inner (Single) The common currency and the common market for goods and serv- • The • • • followed the monetary policy rate of the of rate policy monetary the followed closely has and euro the to rate exchange its fixed has Denmark The monetary and fiscal policy records of the three outsiders rela- up to annual inflation has deviated less from the been the same as the (weighted) average of the euro area, while its of the of relative to substantially very debt public large originally its reduce to able Sweden has also had a positive average fiscal balance and has been rate. the from deviation average lower somewhat a age inflation rate – ecb in the euro area, with relatively small deviations. It has had a lower inflation rate – Sweden’s monetary policy rate has closely followed that of the tially on the positive side since the same course as that of the euro area but has deviated substan - Its ance and has been able to reduce its public debt very substantially. Denmark has, on average, had a substantial and positive fiscal bal- 1999 than in the euro area in terms of a weighted average, and 2008 when it had to raise the interest substantially above that gdp rate but at a consistently higher level. It has had a lower aver- monetary policy rate of the 2008 – and the same average deviation from the target rate. ecb -gap – the deviation of to defend the fixed exchange rate. Its inflation rate has gdp . Its 1.6 as compared to gdp S gap has followed the same pattern as that weden and 14 ) ( gdp 2005. uk 1.4 as compared to has followed the pattern of the from the trend – has followed 2.1 per cent up to

ecb 2 per cent goal. , except in the fall the in except , per cent target cent per 2 2.1 per cent 2008– and ecb . the • the • trade • investment, wage setting and political influence. It concludes that The report also considers the possible effects on trade, foreign direct the • it has been consistently higher than that of the The monetary policy rate of the a • the • euro area. We conclude that Sweden, its business cycle has been less synchronized with that of the its • Sweden’s • conclude that ecb the of that followed closely also has Sweden’srate policy monetary Denmark • its monetary policy rate has closely followed the The fact that Denmark has fixed its exchange rate to the euro and that The • political influence due to remaining outside hasof beenloss slight. the since extent considerable any to affected been have positive, persistent changes. and the with more persistent changes. union, as well as in both growth and inflation if it had participated in the monetary monetary union in the joined had it if performance actual its to similar quite been performance if it had joined the monetary union in euro area, but deviated substantially in the deficit. The country’s relative to that of the euro area while public debt remained at a constant level and its more nominal three effect uk effect fiscal balance of the of balance fiscal would would probably have experienced somewhat higher rates stable uk gdp outsiders’ on on would gdp macroeconomic than for Denmark, effective have wage gap has remained similar to that of the euro area. We the nominal until recently, when there was a drastic increase in inflow have increased setting 1999, and general exchange effective had of is gdp uk investment political unclear, essentially substantially, performance 15 ) ( uk has been negative but smaller than smaller but negative been has -gap has followed the pattern of the rate exchange has followed the same pattern but would influence and would the 2004–2005. rate, and have would same ecb probably ecb more in together been . Compared with the macroeconomic ’s suggests that probably 1999. so eu more for would not have with Sweden stable, more been have 15 introduction and summary 16 chapter 1 The • better record than the flexibility and a relatively low level of unemployment. Sweden has a euro. It would therefore clearly gain by joining the monetary union. the to krone the tied has it since independence policy monetary no of unemployment to participate in the monetary union. It has little or lic finances, fiscal policy-making, labor market flexibility and the level The report concludes that The • The • signed to the three main arguments: as- weight the on depends union monetary the join to decision The S hould hould Denmark, ven against macroeconomic volatility and currency speculation. member states in euro countries. The experience of Denmark, Sweden and new dependent on trade and about half of their exports is directed to tween the euro and other currencies. The three outsiders are very be - distributed is trade how and trading country’s the of extent the on depends argument this of weight exchangeThe tive rate. Sweden the The weight of this argument seems to be stronger for Sweden and market flexibility increases the ability to adjust to shocks. Labor countries. euro most to compared markets labor flexible of the labor market. Denmark, Sweden and the their ability to use fiscal policy for stabilization. (3) The flexibility reducing high public debts to relatively low levels. This increases that has been very successful in maintaining fiscal discipline and rules-based framework for fiscal policy with wide political support a have particular in and Sweden Denmark policy-making. fiscal but not as highly as those of the core countries. (2) The quality of business cycles are highly synchronized with that of the euro area, by steadily increasing economic integration. The three outsiders’ synchronization of business cycles, which is increasing over time of level The (1) factors: three on depends mainly argument this of weight The policy. monetary independent an for substitute tain ability to stabilize the economy. Fiscal policy is not a perfect uk benefit loss benefit than for Denmark. and the of of monetary of more uk a more 2008 demonstrates that the euro can be a safe ha- are also well positioned in terms of labor market uk trade S independence in terms of fiscal discipline, but both have stable Denmark is well positioned in terms of pub- weden and the UK join? and 16 ) ( possibly nominal and, of – more and consequently, thereby investment uk have relatively real of inflows. – a effec- cer- eu

increasing economic integration. been small during the past ten years, and should decrease further with policy. The benefit of an independent monetary policymonetary has,independent the however, up giving of cost the outweigh stability benefits of more trade and increased nominal and real exchange rate relatively low levels of public debt. It is not clear at present that the 17 ) ( 17 introduction and summary chapter 2

MONETARY POLICY

rom t h e v e ry beginning, the single currency has been controversial. Economists pointed out that it did not meet the Optimum Currency Area criteria. Ordinary people were wondering why they should give up their national symbols. Some eu member countries were highly skeptical, and two of them actually obtained an exemption. Although other monetary unions had been functioning satisfac- torily, never before had several developed countries, some of them quite big, decided to adopt a common currency. Ten years on, there is no doubt that the euro area can in fact function, pretty well. Many of the old fears have simmered down, but new ones have emerged. It is noted in the first part of this chapter that inflation has been lower than ever before during the postwar era, but that growth has been disappointing and that the ecb has not developed convincing monetary policy or communication strategies. The monetary union was created mainly to »complement the Single Market«. Although the euro lies at the heart of the European Union, several countries have failed to adopt it. Some of these are

( 18 ) lic opinion polls show that, at least until the recent rise related to the their persistent effect on people’s minds. Nonetheless, the same pub- jumps concerned cheap and oft-purchased goods, which may explain changeover.the of time These the at price in jumps the by affected of the euro has been a major source of inflation. Clearly, they are still (Greece, Italy, Spain and Portugal) has been countries immense. some to benefit The banks. central of independence the institutional choices embedded in the Maastricht Treaty, in particular stability was by definition a key objective. It is also testimony to the price achieved, been has which rates, exchange intra-European of stability cannot be exaggerated. Along with controlling the instability all the euro area countries, see Table in long so for low so been never has inflation experience, postwar central banks of the euro countries, which implement it. fault lines. Turmoillaunched challenge.serious a some revealed already has It Great The Moderation. Great The of end the marked and – crisis financial the and prices commodity in increase sharp the – shocks major two saw euro the of year tenth The future. the in success tee ing the non-euro area members. finance ministers – is assuming growing importance, in effect sidelin- any possible such forum. Yet, the Eurogroup – the group of euro area of size sheer the is another coordination, for case strong no is there not progressed very much so far – will be taken has which something – up. policies macroeconomic coordinate to how One of these is that of issue long-debated the where chapter, the of part seccond the in then, and are even less appropriate now. This issue will be developed that were designed for launching the monetary union were debatable criteria The it. for fit deemed been not have which states, member older member states, who decided not to do so, while others are new Treaty,stability.price is Maastricht the in stated as Eurosystem, the of objective prime The I T N he record he 1. FL Surprisingly, however, most Europeans believe that the adoption The concluding section notes that success so far does not guaran- The Eurosystem consists of the AT I ON : A : S U CC 1 This goal has been achieved. In the whole achieved.the been In has goal This E SS ecb 19 ) ( , which decides on monetary policy, and the 2.1 . The achievement of price 19 MONETARY POLICY 20 chapter 2 and immigration. In the latest survey it has leaped to first place (37 two most important issues« by Table 2.1 I 2.1 Table S concern. major shocks, a price be commodity to and ceased oil had inflation librium changes when some countries go through a catch-up process. return to equilibrium. Real exchange rate movements are also equi- er euro area members. In such a case, we simply observe a welcome which explains Germany’s subsequent real appreciation vis-à-vis overvalued, initially was Deutschmark the that agreement much is however, can be tricky. Figure Interpreting countries. member all fits size one policy’s tern is raising concerns, in particular whether the common monetary its real effective exchange rates vis-à-vis changes. significant This undergone is shown have for rates some exchange countries in real Figure result, a As area. Not surprisingly, inflation rates have not been equal within the euro Inflationdifferentials and it applies to all dependence is another major benefit from the adoption of the euro, particular industries or even particular companies. Central bank in- but many of them were actively involved in channelling savings into deficits, budget finance to upon called routinely banks central were dependence until the Maastricht Treaty called for a change. Not only ource: I ource: 2. 1955–1998

1999–2008 1999–2008 1955–1998

Divergences can reflect initial over- or undervaluation. There orundervaluation. over- initial reflect can Divergences In most European countries, central banks enjoyed very little in- Eurobarometer surveys show that in MF. 2

nflation before and after the euro. the after and before nflation n Luxembourg A eu ustria 3.8 3.7 2.4 1.9 member countries. 16 % of respondents, far below unemployment, crime 20 ) ( p etherlands Belgium 2006 inflation is mentioned as »one of the 4.0 4.0 2.0 2.2 35 other countries. This pat- Finland s ortugal 10.3 6.3 1.7 2.9 2.1, which exhib- %). France 8.8 pain 3.2 5.6 1.7 oth- 2.1, Germany D s enmark 3.1 1.6 2.1 2.1 Greece 10.5 s weden 3.2 3.2 1.2 u witzerland I reland 0.9 6.8 6.5 3.7 nited nited Kingdom I taly 2.3 4.2 7.3 2.7 S I 2.1 Table ource: I ource: 1955–1998

1999–2008 1999–2008 1955–1998 MF. nflation before and after the euro. the after and before nflation n Luxembourg A ustria 3.8 3.7 2.4 1.9 p etherlands Belgium 4.0 4.0 2.0 2.2 Finland s ortugal 10.3 6.3 1.7 2.9 France 8.8 pain 3.2 5.6 1.7 librium nature. Inflation rates can differ because some countries du- real appreciation. real appreciation. This seems to be, in part, what has driven Ireland’s continuing a predicts principle Balassa-Samuelson the case, that In S R 2.1 Figure Germany D 100 140 ource: ource: 130 105 120 13 125 s enmark 110 90 115 95 3.1 1.6 2.1 2.1 5 Some concern is justified when the changes are not of an equi- an of not are changes the when justified is concern Some 199 A 59 M EC 96 O . 79 eal exchange rates in selected countries. countries. in rates selected exchange eal Greece 98 10.5 s weden 3.2 3.2 1.2 90 2000 21 ) ( u witzerland 10 I reland 0.9 6.8 6.5 3.7 02 30 Gr 04 eec e 50 Ir nited nited Kingdom eland Italy German 06 I taly 2.3 4.2 7.3 2.7 Spain 7 y 08 21 MONETARY POLICY 22 chapter 2 GR that exhibit real appreciation not linked to equilibrium forces. dence is that current accounts have turned negative in most countries to know whether the Walters Critique should be dismissed. The evi- gate demand, eventually bringing inflation rates down. It is too early bound to undercut external competitiveness and thus reduce aggre- tion is most likely unjustified. Indeed, continuous real appreciation is inflation and real interest rates is undeniable, the doomsday predic- between link the While union. monetary the threaten and diverge tion countries. The concern is that inflation rates would increasingly that the common monetary policy is more expansionary in high infla- that real interest rates are lower where inflation is higher. This implies return later, with a negative conclusion. the adoption of the Stability and Growth Pact, an issue to which we inflation in Greece, Italy or Portugal, for example. This might justify of wages in the public sector, sometimes seen as the source of higher demand ahead of potential growth. A particular aspect is the raising raise continuously which policies, fiscal undisciplined pursue rably union. fulfill pass the convergence criteria to be admitted into the monetary to had countries member all because low was inflation Moreover, a than depreciation euro a less was it fact, been used by a hawkish Eurosystem to drive up its interest rates. In existence were marked by its sizeable depreciation, which could have ducting its policy in a flexible manner. The first quarters of the euro’s carefully picked to emphasize the legacy of the Bundesbank. were further fanned by the Eurosystem’s chosen terminology that was sue that should not »prejudice the price stability objective«. Such fears rosystem’s primary objective, with »the economy« as a secondary is- from the Maastricht Treaty, which identifies price stability as the Eu- glecting economic growth and employment. These fears sprang partly to establish a reputation as a determined opponent of inflation by ne- launched, there was widespread fear that the Eurosystem would seek was euro the Before instrument. countercyclical powerful a be can policy monetary hand, other the On Eurosystem. the concerns that run growth is not related to monetary policy, so this is not a question Growth in the euro area has generally been a lackluster affair. Long- Another worrisome feature is the Waltersnotes whichthe Critique, is feature worrisome Another It soon appeared rapidly turned out that the Eurosystem was con- O W T H: NO H: LU C K 22 ) ( us dollar depreciation. dollar carefully the pros and cons of the various positions that we could would take, say that we had a very important discussion, weighing up very »As you know, we do not vote needed: and not have are never they since voted taken in not the are votes past. that […] and I consensus by reached are decisions that states explicitly Eurosystem the that therefore, surprising, is It vote. majority a require decisions policy European Central Bank, Art.10. possibly, decision-making, as discussed below. quite and, communication complicates (deeds) practice actual and (words) strategy official the between disconnect The banks. central inflation-targeting as acts Eurosystem the purposes practical all for evolution of central banking and with its own actions. As noted money above, growth matters puts its official strategy at odds within rank second to pillar the general etary aggregate reference growth rate –led to demoting the monetary of money demand – and the Eurosystem’s inability to follow its mon- strategy has been controversial from the start. Continuing instability two-pillar the why explains This strategy. targeting inflation the to pillar.late monetary Bythe the on ulation proceeded, the Bundesbank gradually decreased its reliance public’s demand for money proved to be less stable as financialThis explains the dereg- monetary pillar. However, essentially because the central banks, championed monetary growth targeting in the Bundesbank, whose credibility the Eurosystem sought to borrow. of all other relevant factors. This strategy is directly inspired from the analysis of a monetary aggregate (m3) growth rate, and (2) an analysis the interest rate to achieve this objective based on two pillars: ( 1) an use will Eurosystem the states also It objective. main its as stability per cent – which is a strategy includes a definition of price stability – close to, butThe below detail. much in out laid been has fact in which strategy, its to Discussions of what the Eurosystem is trying to achieve directly M points cision- making process within the Eurosystem. the within process making cision- The Maastricht Treaty provides precise instructions regarding the de- DE 3. ON The Bundesbank, arguably one of the world’s most prestigious most world’s the of one arguably Bundesbank, The C Protocol on the Statute of the European System of Central Banks and of the of and Banks Central Systemof European the of Statute the on Protocol I E S TA I ON RY P RY -M A O KI LI de facto objective since the Treaty assigns price N C G: Y ST Y . Still, the Eurosystem’s insistence that insistence Eurosystem’s the Still, 2003. A MUDDLE R 23 ) ( AT EGY s, best practice had shifted had practice best 1990s, 3 It clearly states that states clearly It 1970s. 2 23 MONETARY POLICY 24 chapter 2 genuine debates tend to produce better decisions. evidence that group decision-making is effective, which suggests that the of view in worrying is This slight. is view minority a develop to not acknowledged. Given these conditions, the incentive for anyone are but heard be may views minority consensus by taken are sions see Cukierman (2007). (2008), Svensson (2005), Walsh (2007) and Woodford ( 2005). For an opposite view, and ultimately came to the decision, by consensus.« ency. recent years research has built a strong case for central bank transpar- A related question concerns is the transparency of the Eurosystem. In T which includes the six Council, Governing the by taken are Decisions country. member particular any of wishes the against go decisions any that pression preparation for its enlargement. This is confusing, to say the least. Eurosystem has taken the initiative to propose a new voting system, in estimated probability estimated an suggest records voting their publish that banks central other of etary policy in particular, is infinitesimal. Taken together, the records mon- on and anything, on agreeing always their of probability The lot. argumentative an be to known are however, Economists, time. the all agreed systematically Council Governing the of members the all if wonderful be course of would It legal. purely the beyond authority of the Eurosystem. the sap could that interpretations ill-intended or erroneous against shield a is rule consensus the Thus, resist. to difficult be could that are taken, it is felt, would prompt requests for revealing information, Admittingvotes conditions. that national discuss to forbidden even countries, even though they do not represent their countries and are that the decision in question runs counter to the interests of their own indication an as seen be could governors bank national by position ernors of the national central banks. The risk, it is argued, is that op- R 7. 6. 5. 4. The Eurosystem’s response is that it wants to avoid giving the im- This is a valid concern, but there are powerful counter-arguments ANS For instance, Bernanke (2007), Blinder (1998), Geraats ( 2002), Gosselin et al. Blinder and Morgan (2005) Geraats et al. (2008). Trichet (2008). 7 The argument is based on the old Milton Friedman conclusion, P A RE NC Y: BEHI Y: 1. · ecb 10 Executive Board members and the gov- -22 N per cent. per 24 ) ( D T D HE C HE 5 It follows that when deci- when that follows It URVE URVE 6

4 Nonetheless, the ciphered by the markets. This is a narrow definition of transparency. code words – sometimes referred to as traffic lights – that are then de- markets for its next decision. Over the years, it has honed a system of takes the markets by surprise. Rather, it endeavors to »prepare« the of guesswork that might be not only misguided but also divisive. attributed, the Eurosystem points out that there would still be the risk tionalistic reactions. To critics who note that minutes are not always na- unleashing of fear the namely previously, as same the is reason The do. banks central leading other many as Council Governing of the twelve-member interest rate and once for housekeeping. policy meetings. policy Governingthe after immediately conference press a hold Council’s of communication. The President and Vice-President of cannot succeed if the central bank is opaque. alone communication however, Ultimately, strategies. munication explains the extreme care that central banks now accord to their com- tion when it can affect expectations about its own future actions. This follows that a central bank is more successful at achieving low infla- is about choosing the appropriate interest rate. From this, it naturally plies that monetary policy is as much about shaping expectations as it im- This output. and inflation of driver key a are expectations term long- which to according label, NewKeynesian the under updated the maximum and minimum forecasts. with Federaltogether Committeeof members, Market range Open makers. The Federal Reserve produces a chart showing the median policy the of forecasts publish Riksbank, Swedish the and Norway of Bank the England, of Bank the as such banks central some this, to the contrast of In Governing views members. the Council reflect that these forecasts are produced by the staff and do not necessarily forecasts four times a year. At the same time, however, it emphasizes improve its transparency. The that observers will have to »read in-between the lines«. ardized and frequently resort to code words, leaving the impression 9. 8. The Eurosystem claims to be fully transparent, insofar as it never its of minutes the publish to refuses adamantly Eurosystem The Right from the start the Eurosystem has recognized the importance Over the years the Eurosystem has shown a certain willingness to The range is a band that excludes the three highest and the three lowest forecasts The Governing Council normally meets twice a month, once to decide on the 8 However these conferences are extremely stand- extremely are conferences these However fomc . ecb 25 ) ( now publishes output and inflation 9

ecb always 25 MONETARY POLICY 26 chapter 2 announcing decisions. mainly as a signal of central banks’ short-term intentions. affecting long-term expectations, while »next moves« are important by primarily operates policy monetary that idea the contradicts It quarters. byeachasquarter the reported forecasts inflation year-ahead one year quarter before. S I 2.2 Figure duced. A glance at the data, however, provides a suggestive answer. monetary policy. No formal evaluation of this issue has yet been pro- partial transparency, as theory predicts, reduces the effectiveness of whether is then question The aims. longer-term communicating to cate its near-term intentions, it is much less transparent when it comes actions will be over the next two or three years. the future policy interest rates, i.e. their own best guesses of what their Sweden, Norway) which have started to Zealand, (New publish banks central their some own of practice forecasts the of with contrast in ource: ource: 10. 4 Thus, while the Eurosystem makes obvious efforts to communi- to efforts obvious makes Eurosystem the while Thus, 3 2 1999 1 Q1 Some critics argue that the Eurosystem should not even tie itself down by pre- E CB. CB. N 2000 ote: ote: » Q3 nflation: Forecasts and outcomes. and Forecasts nflation: O utcome« is inflation measured each quarter in eachquarter to relation measured is the utcome« same inflation T he »forecast« curve indicates the corresponding average two- average the corresponding he curve indicates »forecast« Out 200 Q1 c 2 ome 200 26 ) ( Q3 3 2005 8 quart Fo Q1 r ecast m E ers ahead CB, CB, moved by forward eight 2006 oved Q3 10 This stands 2008 Q1 holding its policy rate at rate policy its holding Eurosystem’s main refinancing rate as subsequently observed. After by the parison is provided in Figure – extracted from the yield curve – with the policy rate. Such a com- of checking this is to compare the instantaneous forward interest rate closely over the normal policy horizon of two to three years. One way bank is transparent, the markets should be able to anticipate its actions outcome has systematically exceeded expectations. the although credibility, of level high a established has Eurosystem Eurosystem’s stated »medium-run« objective. This suggests that the ecb started to raise this in December the stability of inflation forecasts »close to, but below with the corresponding inflation outcome. The striking feature here is Figure D S I 2.3 Figure over over fiveas years byimplied the 3.4 4.2 3.6 3.8 ource: ource: ecember 2006 to 2006 ecember 4 2006 Dec. rdblt, oee, ifr fo tasaec. f h central the If transparency. from differs however, Credibility, started to publish the yield curve and the implied forward rate, E ecb N CB. displays inflation forecasts for two years ahead, together ahead, years two for forecasts inflation displays 2.2 in December ote: ote: 200 S Dec. eptember 2008. 2008. eptember T nterest rates: rates: nterest he blue curve indicates he the blue curve indicates 7 D 2006 over a period of five years as well as the ecember 2006 yield curve. 2006 ecember per cent for cent per 2 2008 Dec. A T ctual and expected. expected. and ctual 2.3. It shows the forward rate computed he red curve shows the simultaneous forward rates he forward red curve shows the simultaneous 27 ) ( 2005. By December E urosystem’s main refinancing rate from main refinancing urosystem’s 2009 Dec. months, the Eurosystem the months, 30 2010 Dec. 2 2006, when the per cent« – the Dec. 2011 27 MONETARY POLICY 28 chapter 2 both at the same time – with the financial crisis probably biggest ever another phenomenon that strikes fear in central banks. Having to face rise in food prices, was one such dreaded event. Financial instability is a central bank can face. The in production costs are among the most challenging disturbances that inflation-fighting central bank – luck has obviously helped. Yet, it does not deserve to be singled out as a particularly successful institution handling a large and relatively diversified economic space. the other central banks, which is no mean feat for a new and untried made mistakes and been less successful. In fact it has done as well as roles of these various factors. Obviously, the Eurosystem could have shaping expectations both came to be better understood. improved as the inflationary process and the role of central banks in central banks. It also helped that monetary policy strategies had Yetvastly another reason was the widespread adoption of independence for tral banks in the more advanced countries to achieve price stability. Central and Eastern Europe and Asia, which made it easier for cen- shocks. Another reason was the emergence of low-cost competitors in tion was ubiquitous. One reason was that there were few inflationary Moderation,Great The whichas during to infla- referred low times Switzerland and the the and achieved in the non-euro area member countries (Denmark, Sweden acle? In fact, Table scored an unmistakable success has on Eurosystem the the key transparency, inflationlimited front.and Isstrategy poor thisWith a mir- MIR transparency reduced the effectiveness of monetary policy. actually less tight than had been intended by the Eurosystem. Lack of nel of monetary policy operates via the long-term rate, the policy was already suspended the tightening trend. Since the interest rate chan- above rate policy the ing would lead. In fact, the Eurosystem would probably have raised underestimating the interest rate had already reached that the interest rate would peak at the policy rate had reached The Great Moderation came to an end in Economists are currently attempting to disentangle the respective AC uk LE O LE ) and most other developed countries such as Canada, as such countries developed other most and ) R LU R 2.1 shows that record-low inflation has also been us. Indeed, the period up to mid-2007 is - some 4.25 per cent rate to which the current tighten- C per cent earlier, had the financial crisis not crisis financial the had earlier, cent per 4 K? 3.5 per cent. At first, the markets thought 2007-8 oil shock, aggravated by a sharp 28 ) ( 3.5 per cent, the markets were still 3.9 per cent. A year later, when the 2007. Sudden increases include all the not does It characteristics. particular two has union monetary The Policy coordination and the outsiders lucky break for the Eurosystem. another been have therefore may and unexplained remains which euro, the of strength the to related undoubtedly is This economies. tion seems to have risen less in the euro area than in other advanced as this is written. any conclusions, or even to tell the story, since events are unfolding known – is truly putting central banks to the test. It is too early to draw other. and the coordination of fiscal policy among the the between their actions. This question in turn, can be divided into coordination it can be used raises the question of how the fulness of fiscal policy is a matter of much debate, but theon fiscal very policy fact only that as a macroeconomic management tool. The use- and rightly so. Consequently, individual euro area countries can rely cy to the area as a whole, rather than to particular member countries, As instructed by the Maastricht Treaty the Eurosystem tailors its poli- COO at many levels: the levels: many at fers. administration, the Common Agricultural Policy and regional trans- 1 per cent of is no federal budget. The Commissions budget is very small (just over teristic is that monetary policy is a »federal« undertaking – but, there eu the of countries only Market, Single the within stability rate exchange provide account of their relative size, this means a total of total a means this size, relative their of account on others than more matter countries some Although bank. central Treasuries of outsiders, the coordination. policymakers when member countries into insiders and outsiders. The other charac - The only observation that can be made at this stage is that infla- that is stage this at made be can that observation only The Macroeconomic management in the in management Macroeconomic RDI NAT eu governments and the central bank on the one hand, one the on bank central the and governments n eu ’s I have adopted the euro – a situation that divides that situation a – euro the adopted have 27 ON gdp members. Although one fundamental idea was to n = Treasuries of euro-area countries, the countries, euro-area Treasuriesof n WI ) and limited essentially to three main domains: 16. This raises a number of issues regarding T 27 – HI N 29 ) ( n central banks of outsiders, and one T HE EUR HE eu O is therefore conducted therefore is n + A n governments on the 1 actors coordinate RE 54 – A + n , or 1, 27 – 16 39 n 29 MONETARY POLICY 30 chapter 2 actions, etc. actions, inter- multi-level coalitions, form can who players of multiplicity a costs, coordination objectives, different coordination: for case the undermine arguments Many desirable. always is coordination that viously, monetary and fiscal policies interact, but that does not mean externalities, i.e. when one actor’s actions affect the other of actors. presence Ob- the in desirable is coordination principle, In dination. together arrangements are formal rather than effective. The Eurogroup brings of the does not take votes. Conversely, the Eurogroup invites the President Eurosystem, without a voting right. However, as noted, the Council the of CouncilGoverning the of meetings the attend can Ministers Finance of Eurogroup the of President The bank. central the and certainly weaken the case for it. not necessarily add up to a strong case against coordination, but they can make coordination counter-productive. Such considerations do accepted. Finally, the fact that we do not know from far what is – the welfare increase best to model solely act is they that i.e. – nevolent national central bank governors, the six members of the ernments refrain from commenting on monetary policy. Such com- central banks abstain from commenting on fiscal policy, much as gov- tries where the central bank is independent, it is an unwritten rule ference that after the Governing Council’s policy meeting. In other coun- national fiscal policies. This is part of the regular monthly press con- price-stability objective. These rules out any formal coordination. reluctant to be drawn into actions that are not fully consistent with its sionally at least, bind certain decisions. The Eurosystem may thus be occa- must, coordination effective, be to Obviously, governments. independent status reduces its scope for coordination with member Treasury deputies, to which the are held in other fora, for example the Eurogroup Working Group of too short to allow for any serious give-and-take. Detailed discussions and the President of the Eurogroup). Their meetings are normally far 11. It is by no mean clear that coordination is better than non-coor- than better is coordination that clear mean no by is It The Treaty envisions some coordination between the governments On the other hand, the Eurosystem systematically comments on The members of the Eurosystem have also hinted that the system’s See Pisani-Ferry (2006). ecb n + when it discusses issues affecting monetary policy. These 11 1 participants and the Eurosystem’s size is Moreover, the presumption that governments are be- are governments that presumption Moreover,the ecb 30 ) ( is also invited. n + ecb 7 (the Board n P that could conduct face-to-face discussions with the This has led some to suggest establishing an »economic government« mix of centralized monetary policy and decentralized fiscal policies. reducing public deficits, not at assigning responsibility for a desirable tend indeed to lead to procyclicality. policy discipline, an important attribute of good policy, but its rules this is not working. This is not surprising. The pact is focused on fiscal es itself by the degree to which its policies are procyclical suggests for that example in Fatás and Mihov (2008), that the euro area pressure distinguish- that can improve the quality of national policies. Evidence, ity. This has led some to defend the Stability and Growth Pact as peer the view that fiscal policy actions are not always of impeccable qual- reason for any restriction on policy independence could be based on to the exchange of information about future policy actions. The only cies should become similar. Coordination therefore should boil down deal with local conditions. There simply is no reason why fiscal poli- policy instrument, it would seem logical that each country uses it to to such a body. of economic government have never clarified the tasks to be assigned remains far from constituting a government. In fact, the proponents Growth Pact and in promoting the »frank« exchange of views, but it euro group plays an important part in implementing the Stability and The coordination. greater advocating been have that – France ular group has been created partly to placate those countries – in partic- tive Board and the governors of all the policy.fiscal on ordination times claimed that the Stability and Growth Pact could allow for co- can upset relations between the central bank and the government. ments are usually counter-productive, since they are ineffective and The Eurosystem’s Governing Board brings together the T policy is discussed informally in many fora and on a bilateral basis, bilateral a on and fora many in informally discussed is policy Monetary role. policy-making any lacking arrangement formal a is HE O HE O 13. 12. In fact, since fiscal policy is the only remaining macroeconomic remaining only the is policy fiscal since fact, In Coordination between governments is even murkier.even is some- governments is Coordinationbetween It LI Pisani-Ferry (2006). Brunila et al. (2001 ). C U Y I Y TS N IDER T HE EUR HE S AN O D M D 12 A This is questionable. The pact aims at aims pact The questionable. is This RE ON 31 ) ( A E TA eu RY national central banks. This

ecb ecb . 13 The euro Execu- 31 MONETARY POLICY 32 chapter 2 quirements for membership of the euro area. euro the of membership for quirements re- the of one as States) Baltic the (like others choice, by Denmark is that Sweden is considerably more integrated with the flexible strategies regarding inflation. The most logical interpretation similar very adopted have countries both since surprising hardly is This euro. the vis-à-vis stable very remained has krona the period, learning) (possibly initial dollar.an the After and euro the between reactions in Sweden and the undergone considerable fluctuations. Figure exchange rate against the euro within a band around the so-called central rate. tive to the euro. Some of them have joined the eu exchange rates. Given the economic size of the euro area within the but there is no explicit or implicit attempt to coordinate or deal with fied the task for outsiders’ central banks. risk of sharp fluctuations in exchange rate and has significantly simpli- fect follows a flexible inflation-targeting strategy has thus reduced the ner vis-à-vis the euro. Mounting evidence that the Eurosystem in ef- monetary pillar may help to explain the the initial to fluctuations and inflation ofto theattention kro- undue pay would Eurosystem the rate stability vis-à-vis its main partner, the euro area. Early fears that mestic objectives while also benefitting from considerable exchange resembling a local one, an outsider’s central bank can pursue its do- ture of monetary policy. So long as the Eurosystem follows a strategy and closely integrated with the countries outside it, especially if their economies are small, very open by the Riksbank. regard the krona/euro exchange rate as too important to be ignored also markets exchange the Perhapstoo, rates. exchange in stability considerable generate to similar sufficiently are policies monetary euro area. Since the Eurosystem implicitly follows a uniform strategy, uk major currencies – the euro and the Republic, Hungary and Poland – keep postponing their decision. have decided to shun any such commitment. The others – the Czech 14. , outsiders obviously need to monitor their exchange rates rela- rates exchange their monitor to need obviously outsiders , is, so that its economic situation resembles that prevailing in the This shows that events in the euro area matter a great deal to the To simplify somewhat: the outsiders are caught between the two By joining the erm (Exchange Rate Mechanism), a country agrees to keep the uk. Sterling has followed a middle path eu 32 ) ( . This applies in particular to the na- us dollar – both of which have 2.4 shows the different 14 erm Sweden and the Swedenand – some, such as eu than the uk

10 12 11 6 9 8 5 7 1999 M1 200 M1 1 Dollar 200 M1 S WEDEN 3 2005 M1 Eur o 200 M1 7 N E 2.4 Figure ote: ote: 0. 0. 0. 0. 0.7 10 12 11 6 9 8 5 7 4 6 8 5 1999 1999 M1 T M1 he exchange he rate exchange is as or pounds measured per kronor euro S or dollar. 200 200 M1 xchange rates vis-à-vis the euro and the dollar. the dollar. and the euro vis-à-vis rates xchange M1 Dollar 1 1 Dollar 200 200 M1 M1 S WEDEN 3 3 33 ) ( UK 2005 2005 M1 M1 Eur Eur o o 200 200 M1 M1 7 7 ource: ource: I MF 33 0. 0. 0. 0. 0.7 4 6 8 MONETARY POLICY 5 1999 M1 200 M1 Dollar 1 200 M1 3 UK 2005 M1 Eur o 200 M1 7 34 chapter 2 ciated vis-à-vis the euro. fected by the crisis) both of whose currencies have significantly depre- to the world’s second largest financial market and therefore more af- a new challenge. This applies to Sweden as well as to the in Sweden. It only suggests a degree of similarity. Macroeconomic policy coordination at the COO they face the hurdle of a referendum. The but area, euro other the join to like countries would they that repeatedly do indicated not enjoy have authorities Danish The limited. is policy monetary regards as clear-cut. The krone is de facto attached to the euro, and autonomy more is case Danish The question. valid a is currency independent appear to be limited. benefits the but autonomy, policy monetary its exploiting been has it is possible to imagine it remaining in place indefinitely. Sweden too arrangement is considered to be satisfactory, which it has been so far, the that gests tending to remain outside the euro area indefinitely. Figure informal exchanges among the central banks may be sufficient. current situation can be regarded as purely transitory, and the the light, current this In stipulate. treaties European the what is this fact, in exchange rate stability, they will end up by joining the about concerned euro really are outsiders area. the if And logic, that Accordingto currency.common a of adoption the to led eventually that process of exchange rate stability within the Single Market that triggered the is a very important variable. In fact, it was precisely the importance noted in the previous section, to the outsiders, the euro exchange rate mon interest and exchange rates – are not in fact present. And yet, as since the externalities presumed to exist within the euro area – com- ers? this imply that it is even weaker between the insiders and the outsid- argument for tighter coordination within the euro area is weak. Does the that earlier suggested been has It area. euro the in policy fiscal existent. This is not surprising in view of the limited coordination of 15. The end of The Great Moderation has presented these banks with The situation is different for the countries that are at present in- present at are that countries the for different is situation The The case in favor of fiscal policy coordination is in fact very weak, The exchange rate does not indicate how different monetary policy has been RDI NAT uk I is exploiting its monetary policy autonomy.policy the monetary If its exploiting is ON 15 AT Whether or not they outweigh the costs of an T HE EU LEVEL LEVEL EU HE 34 ) ( eu level is currently non- uk 2.4 sug- (home Greece and Italy. credibility is likely to offer significant benefits, like those enjoyed by Joining a monetary union that countries. has open small already are successfully members new built the of up Most encouraging. its own not are members other eight other the for Prospects area. euro the 2004, only four (Slovenia, Cyprus, Malta and Slovakia) have joined since Union european the joined have that countries twelve the Of EN want – a point that will be considered in the next section. euro. But, also like Sweden, they can postpone the step as long as exemption, they and so, like Sweden, they are committed to adopting the at the time, and they remain so today.so remain they and time, the at eu ously. The convergence criteria were laid down in And yet, economic and legal principles do not always mix harmoni- perfectly reasonable that all countries should abide by the same rules. admission to the monetary union apply to the new members. One implication of this is that the convergence criteria determining members would have to fulfill the same obligations asof Summit olderCopenhagen the at – on members. early decided Table complete. Many of these countries have budget deficits, as shown in unleashing a catch-up process that will take a generation or more to members of the Soviet bloc. They have undertaken massive reforms, former are area euro the outside still are that members new the All tous, its application to the new member states is highly problematic. ubiqui- been has indiscipline fiscal where states member older the untried monetary union. they would not support the general objective of price stability in an had a history of poor monetary and fiscal discipline. The fear was that able – if not all together justified – since several large countries have criteria focus on inflation and budget balance. This was understand- (labor markets, trade integration and diversification), the convergence Area principles suggest that admission be based on concrete criteria 16. members in mind. Even so, the criteria were highly controversial In There is a strong legal basis for the Copenhagen principle. It seems On the other hand, while the deficit ceiling may make sense for sense make may ceiling deficit the while hand, other the On L A This controversy is described in Wyplosz (2006). 2. Some of these are unsustainable, but some are justified by , Lithuania’s application was turned down. It had been had It down. turned was application Lithuania’s 2006, RGEMENT 35 ) ( 16 While Optimum Currency Optimum While 1991 with the then – that new that – 1993 35 MONETARY POLICY 36 chapter 2 wasteful spending. for distinguishing between much needed profitable investments and rife in most new member states, but the deficit ceiling does not allow missed investment opportunities. Fiscal indiscipline is of course also and phase catch-up slower a means therefore deficits the Limiting pay for itself later, when the productivity gains actually materialize. that public borrowing during the catch-up period is almost certain to lic investment is therefore potentially highly productive. This means and obsolete public infrastructure from their previous regimes. Pub- poor very a inherited countries these fact, In process. catch-up the S states. innewmember the inflation and balance Budget Table 2.2 els. whereby their wages and prices gradually move towards the long ago, these countries are subject to the Balassa-Samuelson effect, including excessively expansionary fiscal policies. As was anticipated but there is a common explanation that does not rule out Tableother factors, their inflation rates would converge towards the euro area level. But of their monetary policies. One would expect that, as a consequence, rate. This means that they have very little autonomy in the conduct the euro, and the other new member states also adapt their exchange gence criteria, the Baltic countries have fixed their exchange rates to ource: ource: 17.

Bulgaria L E Czech Czech R P H L E ithuania atvia uro uro area average oland stonia 17 omania Further, as members of the of members as Further, ungary This generates higher inflation – driven not by monetary factors Halpern and Wyplosz (1997). A 2. shows that this has not happened. This may seem strange M R E epublic

O D atabase, european Commission. european atabase,

Budget balance (% balance Budget of G 36 ) ( -5.5 erm -2.0 -2 -1.2 -1.6 0.0 3 2.8 .4 .5

, and thus subject to its conver- its to subject thus and , DP ) 2007

I 2007 10.1 nflation rate nflation 4.8 6.6 8.4 8.0 5.7 2.8 2.5 2.1 2008 eu 10.0 15.8 4.1 6.0 6.3 9.5 9.7 3.2 7.5 lev- conditions. And in fact, this is precisely what we can see happening. adopting a flexible inflation-targeting strategy until they meetthen thethe entry outsiders should simply follow monetary policy best practice, three of which meet the required conditions. If that route is not taken, tries with an opt-out clause (Denmark and the and (Denmark clause opt-out an with tries precedent would be welcome. There remains the case of the two coun- very similar to the current outsiders from the region. In this context exception of Turkey the – are small, open, former transition economies, But all the current and future new member states – with the possible degree of flexibility. Some might fear that thisently – in the case of Greece, and they can be couldintroduced with some create a precedent. tions. They were not applied rigidly in the case of Italy nor – inadvert- quirements. The next best solution would be to reinterpret the condi- adoption of the euro. preclude high inflation or housing price bubbles from occurring after make much difference. More to the point, the entry conditions do not nomic strength of all the new member states together is too small to euro area members faced similar difficulties. This is true, but the eco- more even if worse be would it and helpful not is thing a such that this situation already exists in Ireland and Spain. It could be argued by a boom and a housing-price bubble would create a problem. But the euro by now. In some cases, as in Estonia, high inflation caused Sweden by not joining the euro area at all. emulate to countries these of some whichlead area, might euro the Moreover, delays in admission may sap support for membership of of currency crises within the European Union is clearly undesirable. that these have been the years of The Great Moderation. Any return have beennogreatproblemssince2004,butweshouldremember the by illustrated amply was as instability, potential of source well-known a is exchange-ratepeg an and bility and are all expected to join the mobility capital on restrictions all eliminate to required been have monetary stability, among other things. The new member countries nearly complete. catch-upthe until possibly area, euro the of out countries is process and inevitable. However, excessive inflation is bound to keep these however, but by a relative price-adjustment process that is structural In any case, admission legally remains subject to the original re- original the to subject remains legally admission case, any In Ideally, all new member states should have been allowed to adopt of reasons for disquieting, is delays long very of possibility The erm 37 ) ( . The combination of capital mo- 1993 uk erm ) and Sweden,alland ) crisis. There crisis. 37 MONETARY POLICY 38 chapter 2 July especially if the political leaders start fretting. must reassure the public that it is following a well considered strategy, is inevitably slowing down. In such circumstances the central bank tive monetary policy, which is not easy to impose when the economy expectations from rising permanently. This, in turn, calls for a restric- situation and that the best option is to focus on keeping inflationary resented a supply shock. We know that there is no easy fix in such a rep- prices commodity and oil in increase The challenge. real first With the end of The Great Moderation, the Eurosystem is facing its C willing to clarify the issue. the clarify to willing organization, yet there is no indication that the member area’s countries euro the are in hole gaping a revealed has crisis The needed. as There is no guarantee that the process would be as rapid and effective cost. the bear to have ultimately would who authorities fiscal the of intervene as lender of last resort, but this would require prior activities in approval several countries, were to fail. In principle the wonder what would happen if a large European bank with important or regulators. but it relies instead on national bodies. One might well tional prerogative. The euro area does not have its own supervisors na- a is banks of supervision and regulation the arrangements, rent The main concern is not of its own making, however. Under the cur- fast and apparently appropriately to several acute liquidity shortages. shielding its monetary policy from the financial turmoil. It haswhile provision liquidity ample provides reacted that strategy a crafted has perhaps the event most dreaded by all central banks. The Eurosystem of transparency can be harmful in such circumstances. especially the 19. 18. onclusions: onclusions: testing times ahead The second challenge facing the Eurosystem is the financial crisis – 2008 as the kind of »monetary dumping that sends firms to their knees«. The issue has been identified long ago, see Begg et al. (1998). French President Sarkozy described the Eurosystem’s interest rate increase in uk where all the major banks are represented. 19 This situation also affects the outsiders, the affects also situation This 38 ) ( 18 As noted earlier, a lack ecb could Blinder, AlanS.(1998)Central BankinginTheoryandMonetary Policy Bernanke, Ben (2007)»Federal Reserve Communications«, CatoInstitute Begg, David,Paul deGrauwe,Francesco Giavazzi,HaraldUhligand R Wyplosz, Charles(2006)»EuropeanMonetary Union:theDarkSidesof Woodford, Michael (2005)»Central-Bank Communication andPolicy Walsh, Carl(2007)»OptimalEconomic Transparency«, InternationalJour- Trichet, Jean Claude(2008)Press Conference, 10 January2008(http:// Svensson, LarsE.O.(2005)»Social Value ofPublic Information: m&s Pisani-Ferry, Jean (2006)»OnlyOneBed fortwoDreams:ACritical Halpern, LaszloandCharlesWyplosz(1997)»EquilibriumExchange Gosselin, Pierre,AileenLotzandCharlesWyplosz»How Much Informa- Geraats, Petra, Francesco GiavazziandCharlesWyplosz(2008),Monito- Geraats, Petra (2002)»Central BankTransparency«, EconomicJournal112 Cukierman, Alex(2007)»TheLimitsofTransparency«, forthcomingin Brunila, Anne,MarcoButiandDanieleFranco (2001)»Introduction«in: Blinder, AlanS.andJohn Morgan (2005)»AreTwo Heads Better than eferenc Regimes, Cambridge,MA:mit ke20071114a.htm). 14. (http://www.federalreserve.gov/newsevents/speech/bernan- 25th AnnualMonetary Conference, Washington, D.C.,November the European Central Bank1,London,cepr Charles Wyplosz(1998),»Theecb a MajorSuccess«,EconomicPolicy 46:207–62. Reserve BankofKansas City,KansasCity. Effectiveness«, inTheGreenspan Era: LessonsfortheFuture, Federal nal ofCentral Banking3(1):5–36. www.ecb.eu/press/pressconf/2008/html/is080110.en.html). forthcoming. Is Actually Pro Transparency, Not Con«, American EconomicReview, Common MarketStudies44(4):823–844. Review oftheDebate overEconomic Governance inemu Rates inTransition Economies«, imf Journal ofCentral Banking,forthcoming,2008. tion ShouldInterestRate-Setting Central BanksReveal?«, International ring theEuropean Central Bank6,London:cepr (483): F532–F565. Siklos P. et.al.(eds.),Frontiers inCentral Banking,Elsevier. Basingstoke: Palgrave. A. Brunila,M.ButiandD.Franco (eds)TheStabilityandGrowth Pact, Banking, 789–812. One? Monetary Policy byCommittee«, JournalofMoney,Credit, and e s 39 ) ( Press. : SafeatAnySpeed?«,Monitoring StaffPapers 44(4):430–460. . . «, Journalof

39 MONETARY POLICY chapter 3

FISCAL POLICY

he creation of a single currency in Europe has been accompanied by some major challenges to the role of fiscal policy. The challenges came from two main directions. First, as each country had to abandon monetary policy as a tool for stabilizing its national business cycles, it seemed natural for fiscal policy to take a more promi- nent role in controlling cyclical fluctuations. At the same time, concern about the stability and credibility of the new currency, and the possibility that governments would not internalize the consequences of their behavior, meant that the institutional framework for national fiscal policies became rather restricted, defined as it now was by the limits on debt and deficits of the Maastricht Treaty and further elabo- rated by the Stability and Growth Pact. The run-up to the launch of the euro was difficult and driven by the strict criteria defined by the Maastricht Treaty. With the introduction of the euro at the start of 1999, and the replacement of the Maastricht Treaty criteria by the rules of the Stability and Growth Pact, the issues became broader, shifting from a subject of debate among academics

( 40 ) fiscal policy. The fourth section concludes the discussion. coordination between fiscal policies and examines the stance on euro the national level, while the third section euro? In the next section we describe the behavior of fiscal policy at cal policy has improved or deteriorated since the introduction of the for assessing the quality of fiscal policy. How can we tell whether fis- decreased threefold since tries – in terms of the dispersion of cyclically adjusted balances – has states. Further, the discrepancy in fiscal policy across euro-area coun- quite substantial in the euro area, and appears in most of the member discretionary fiscal policy in all the major economies. This decline is of the countries. We also note a broad-based decline in the and volatility we have of observed a tendency towards countercyclicality in some in the for fiscal policy to become even more countercyclical, as it has done in the euro area than it is in other countries, where we see a tendency rency. The bad news is that fiscal policy tends tocur- benew morethe procyclical of introduction the since much changed not has tries tional setting, the cyclical behavior of fiscal policy in the but were subject to the same fiscal policy constraints. the three members of the hurt the conduct of fiscal policy for the members of the euro area and focus is on understanding whether the new framework has helped or Pact have shaped fiscal policy among the members of the union. Our currency and the constraints associated with the Stability and Growth and the role of automatic stabilizers. We describe how the common the euro in several dimensions: procyclicality, volatility, coordination the very first years of the monetary union. challenge to macroeconomic stability and the credibility of the Pact in in fact became binding for several countries, as well as representing a environment of discipline, coordination and stability, its constraints duct of fiscal policy. Although the Pact was intended to encourage an con- the for framework credible a provide to failed clearly had and bility and Growth Pact had already been subjected too much criticism monetary union, the framework for fiscal policy embedded in thethe of years Sta- early the In policy-makers. for challenge real-time a to The paper is organized as follows: we first provide a framework a provide first we follows: as organized is paper The Our results show that despite the significant change in the institu- of introduction the after policy fiscal Weof behavior the review usa . The good news is that the automatic stabilizers are strong, eu 1999. who opted out of the common currency 41 ) ( considers whether there is coun- eu15 41 FISCAL POLICY 42 chapter 3 pressure will fall on monetary policy to regulate the business cycle. adopting automatic stabilizers in bad times, which means that all the for scope little very have will they debt, of levels unsustainable by confronted are governments if view, of point dynamic a from First, cy can complicate the macroeconomic management of the economy. the stabilization of business cycles. The lack of discipline in fiscal policy, it is also connected in many ways with the discussion of policies for difficult or simply not in the interest of the national governments. with a decentralized fiscal policy where coordination might be more the monetary union. This might be more relevant to a goal monetary of the union central bank regarding the maintenance of stability within nomic volatility, which in turn would make it difficult to achieve the rated by repeated statements from the tainability as the main goal of the fiscal framework. This is corrobo- In the monetary union context, the Maastricht Treaty identifies sus- Su at the logic behind this characterization. should not be a significant source of volatility. We look briefly below good fiscal policy must be sustainable and countercyclical, and that it icy to fluctuations in the business cycle; (3) volatility. We assume that main headings: (1) long-term sustainability; (2) reactions in fiscal pol- three under operate whichthey in environment the and authorities approach in this paper, describing the performance of the fiscal policy stitutes good fiscal policy is difficult to reach. We adopt a very simple the euro area arises from the fact that consensus regarding what con- The first problem when it comes to analyzing recent developments in Definingand measuring »good« fiscal policy rates and lower levels of investment and growth. effect on the economy. Finally, high debt levels lead to short-term a have higher to likely are interest which consolidations, fiscal by ones Secondly, unsustainable plans will have to be made into sustainable macroeconomic stability and cohesion in the euro area«. for prerequisites are They Union. Monetary a of success the for tal policies and a monetary policy geared to price stability are fundamen- 1. 2. While sustainability refers to the long-term behavior of fiscal poli- macroeco- excessive generate may policy fiscal Unsustainable sta Statement of the Governing Council of the As pointed out by Melitz (2000) and Perry (2002). i na bili t y of

fi sca 42 ) ( l ecb

p ecb oli stressing that »sound fiscal , March c y 21 2005. 1

m of fiscal policy. We will now turn to this debate. of the rules have led to debate focusing more on the cyclical behavior implementation the sustainability, long-term was framework policy ibility as a relaxation of the constraints. adjustment should be made, and there are some who regard this flex- of the economy as well. There is no agreement, however, on how this position cyclical the account into taking limits, the of interpretation reform of the Stability and Growth Pact allowed for a more flexible balances that did not correspond with the levels projected. The there were endless discussions on the special circumstances that led to So long as they were still based on simple principles of sustainability, limits on deficits and debt in accordance with the Maastricht Treaty. plans. This has been one of the major difficulties in implementing the impossible to provide long-term guidance with regard to budgetary derstanding of how fiscal policy behaves over the business cycle, it is changes.Withoutun- cyclical proper for a adjusted balance budget the i.e. year, given a in balance structural the capture to necessary term fluctuations in budgets due to automatic stabilizers, it becomes short- the of view In budgets. annual characterizemonitor ure, and of what constitutes a sustainable fiscal policy, it is necessary to meas- implementation of budgetary plans. When it comes to the discussion cyclical nature of fiscal policy – one that is related to the design and stabilizers. Automatic stabilizers tend to be countercyclical, particu- countries, most cyclical changes in budgets are a result of automatic bilizers and discretionary policy, and we cannot forget that, for most tant to recognize that fiscal policy is a combination of automatic sta- would otherwise have been. may force the cits during an economic boom may lead to inflationary pressure and spective of monetary policy, if this last is not the case, then high defi- per- the From »bad«. are they when deficit a and »good« are times when surplus a run to supposed are Governments countercyclical. Fiscal policy as a tool for managing business cycles is expected to be F i ana sca To sum up: although the main concern of the monetary union fiscal the and sustainability between connection another yet is There When analyzing the cyclical behavior of fiscal policy, it is impor- geme l p o ecb li nt o nt c to maintain interest rates that are higher than they y stanc f bu s i e n 43 ) ( an e ss c ss d t y he c le

s 2005 43 FISCAL POLICY 44 chapter 3 Europe. of Latin American economies but mixed for those in the case the in strong is evidence The times). good in more (spending positive. In many countries, governments adopt a procyclical policy cycle. governments’ prediction for policies that generate a political business altered has currencies icy.national of absence the that possible is It there is any evidence of changes in the use of discretionary fiscal pol- text of the monetary union, but it could be interesting to see whether and following the publication of Blanchard and Perotti (2002), Fatás and Mihov (2001a fiscal policy. of measures adjusted cyclically of drawbacks potential the discuss (2007) Morris Mohrand and Blanchard(1993) results. the in bias a create potentially could and strong requires which assumptions on potential output and cyclical elasticities of different policy, fiscal variables fiscal of out component cyclical the extracting of different components. A drawback, however, is that it relies heavily on the process the into decomposed is policy fiscal way the in consistency ensures methodology of fiscal policy for this group of countries. Alesina, Campante and Tabellini (2007) present evidence on the cyclical properties business cycles. confirmed in Fatás and Mihov (2001b) that large governments display less volatile growth. down slow may cases some in which volatility, add simply they if economy the on effect negative a suchhave principle, may policies In consumption. and output in fluctuations to lead changeswill the erally, for reasons that are not driven by economic conditions, then implement changes in fiscal policy for political reasons or, more gen- Fiscal policy can be a trigger of business cycles. When governments Vo a government is related to the safety network that it provides. larly for countries with a large government. The logic is that the size of balance to analyze these two components of cyclical fiscal policy. 6. 5. 4. 3. When it comes to discretionary fiscal policy, the evidence is less The question of volatility has not been a major concern in the con- We will rely on cyclically adjusted 2003), and Burnside, Eichenbaum and Fisher (2004). l The effects of fiscal policy shocks have received a good deal ofattention good a received have shocks policy fiscal of effects The The (2005). André and Girouard see methodology, this of details For and Vegh ( 2004), and Reinhart Kaminsky, (2005), Wyplosz (2003), Lane The reason for this link is the empirical regularity described in Gali (1994) and at 6 4

ili t y 44 ) ( oecd measures of the budget oecd 3

and 5 and to less than to-gdp both cases the trend is stronger than in the euro countries, as the debt- driven by their efforts to qualify for entry into the monetary union. In on all members. Denmark and Sweden display a similar trend, in part preted as a clear sign of the discipline that its entry conditions impose 008ad2 9aefrcss. forecasts are 09 20 and 8 0 20 in the is then a clear downward trend from this point on. The in the same euro countries appeared shows a rising trend until the mid-1990s. There euro area, Denmark, Sweden and the government financial liabilities (Maastricht definition) asdefinition) of percentage G (Maastricht a liabilities financial government as of aliabilities percentage G financial ernment Figure Su Fiscal stance at the national level N Government Gross 3.1 Figure 40 60 80 20 otes: otes: 10 0 sta 19 D Eur uk 72 ata ata are from the 3.1 illustrates the development of the debt-to- gdp ratio drops from over UK i o 12 up to na 19 76 bili 2001–2002. The trend in the euro area has been inter- 40 per cent in Sweden. Denmark 1980 OE t C y D of 1984 E conomic conomic

fi 1988 80 per cent to sca O 45 ) ( D utlook. utlook. ebt (per cent of cent G ebt (per DP 1992 l . For the euro area the are series gross

T uk. The evolution of this ratio p he series he for series the U oli 1996 Sw 20 per cent in Denmark c eden y 2000 DP ). K are gross gov 2004 DP ratio for the . T he he data for 2008 - 45 FISCAL POLICY 46 chapter 3 –4. –8. 0.0 4. 8. N G as a of cent potential per balance budget adjusted Cyclically 3.2 Figure justed balance as a per cent of potential presenting structural budget balances, measured as the cyclically ad- Ireland, the Netherlands or Belgium, which in the mid-1990s started area there have been countries reporting a similar decline – namely euro the within but Denmark, and Sweden in fast falls Debt effect. significant any find to difficult is it figures two these From namics? with a period of faster growth rates. structural balances improve again after euro The declined. clearly debt and deficits reduce to efforts data, to join the monetary union went out in cit limit of the Maastricht Treaty. monetary union candidates, seeking to qualify for the the high deficits in all the countries in the sample. We see once more that odology). The 0 0 0 0 otes: otes: . DP Figure Did the monetary union have any effect on debt and deficit dy- deficit and debt on effect any have union monetary the Did The graph also suggests that once the final call for those wanting s represented years of declining budget deficits for all the all for deficits budget declining of years represented 1990s 19 D Eur ata ata are from the 72 o 12 rvds ute isgt rgrig hs ted by trends these regarding insights further provides 3.2 19 76 1970s, the late 1980 OE C D E 1984 conomic conomic 1980s and the early 1988 O 46 ) ( utlook. utlook. Denmark 1992 D gdp 1998 on the basis of the ata ata for and 2008 are 2009 forecasts. 2003–2004, which coincides ( to adopt the 1996 Sw eden 2000 1990s all showed 3 per cent defi- 2004 UK oecd 2008 meth- 1997 G 3.3 Figure euro area a the three outsiders and the members of the monetary union. any substantive differences in debt and deficit dynamics as between down to about the the cyclically adjusted budget balance. (measured as the as (measured the way this component behaves in the course of the business cycle We can now turn to the analysis of automatic stabilizers by looking at Auto to up of debt a with Output volatility (%) low of a from varies cyclicality Their countercyclical. strongly are pected, 10 12 7. 0 4 6 8 2 0. uk We are measuring automatic stabilizers as the difference between the actual and 20 0.3 (Greece) to a high of these coefficients are mat .25 Japan 1 per cent increase in the gap generates a budget surplus i c stabili US Gr 80 per cent. Thus, the overall picture does not reveal 0. A volatility and automatic stabilizers. automatic and DP volatility eec 30 Portugal gdp Austr e per cent of cent per 140 Canada -gap). .3 alia Switz 50 Italy Ne z Lux Ir 7 UK erland w Z 0.29 and Automatic stabilizers, as might be ex- be might as stabilizers, Automatic er eland .4 embour Fr Austria 47 ) ( 0.65 (Germany), while in the Spain ealand Elasticity s at t anc Finland 0 .45 e Eur gdp g 0.39 respectively. Thus in the o 12 Denmark he 0. but managed to bring this bring to managed but 50 Sw Netherlands nat eden .550 Belgium i l ona .6 Germany

0. level 65 us and 0.7 47 FISCAL POLICY 48 chapter 3 that governments have not engaged in a consistent manner. The evi- of have plotted the elasticity of the overall balance versus the volatility acted aggressively to the business cycle. stabilizing tool? a as policy fiscal used governments have above, described have we in Gali and Perotti (2003) for an earlier period. residual Cyclically adjusted fiscal balance present year = constant + unrelated to the cycle. In this section we discuss the reaction of policy to the cycle. business cycle, while the residual from this equation measures discretionary policy coefficient the stabilizers. automatic of variation time the measuring in point no is there elasticities, these in tax and spending elasticities used by the 0.29 per cent. business cycle. flexibility available to discretionary fiscal policy? the limited debt and deficits on constraints the have Or happened? this Has limited. very is labor of mobility where context European way to smooth the business cycle. This is even more relevant in the policy they need to be more aggressive in the use of fiscal policy as a monetary of absence the in that worried are Nationalgovernments di A of about + between the euro area and the three outsiders. of cyclicality, not in terms of stabilization, do we see much difference Netherlands, while the the as volatility and elasticity same the SwedenDenmarkhave and automatic stabilizers have less volatile cycles. λ × λ l 10. 9. 8. gdp sc Do automatic stabilizers stabilize the economy? In Figure Overall, we do not see strong evidence that fiscal policy has re- has policy fiscal that evidence strong see not do we Overall, We now analyze how discretionary fiscal policy has reacted to the The opt-outs are very similar to the countries in the euro area – area euro the in countries the to similar very are opt-outs The government debt preceding year + oo Discretionary fiscal policy is captured by two measures: In the equation below The automatic stabilizers component that we are measuring is derived from the For empirical estimates see Fatás and Mihov (2009). This is also documented re . The relationship is clearly negative – countries with more with countries – negative clearly is relationship The . k 0.46 per cent, while in the t at nat at iona represents the discretionary reaction of policy to the state of the of state the to policy of reaction discretionary the represents β 8 9 In other words, beyond the automatic stabilizers that ry i ona

fi uk sca is close to Italy. Overall, neither in terms l

φ × φ

l 48 ) ( cyclically adjusted fiscal balance preceding year +

oecd p o us lic . Given that there is no time variation , the surplus goes up only by 10 This could be an indication y β × β state of economy present year 3., we policy rule in footnote half of the sample (after sample the of half ary policy. We also see that this volatility has decreased in the second are in euro countries. euro in are decreases largest the Someof Luxembourg. and Austria,Ireland of are as the standard deviation of changes in the fiscal policy stance which We now look at the volatility of discretionary fiscal policy measured Vo a much larger change towards countercyclical policy. just happening in the euro countries. As an example, in the absence of monetary policy. However, the change is small and it countercyclical, is which not is what we would have expected because of a the small number of years, but there is a tendency for policy to become is difficult to reach strong conclusions, given that we are talking about the euro countries. dence points towards procyclicality at the national level, more so in to and Denmark from down, but they start from higher levels. Sweden goes from The three outsider countries also see their volatility of fiscal policy go monetary union fiscal framework has helped the of discipline the that suggest and claim this support results Our policy.economic volatile less of result a as partly reduced been has debate. There is strong evidence that the volatility of business cycles of fiscal policy fits well with what is known as The Great Moderation provided by the Stability and Growth Pact. This decline in volatility tions. In that sense this could be seen as an indication of the discipline plement changes in fiscal policy that are unrelated to economic condi- governments have not taken advantage of a common currency to im- volatility. This is good news for monetary union. It says that national eu ing that moderation. 12. 11. , Germany from Germany 0.17, -15, only Canada and the Most euro countries display low volatility of exogenous discretion- If we look at the pre- and post-1999 periods, has policy changed? It not related to the state of the economy. l at The estimates reported in this section are based on Fatás and Mihov (2009). the estimating when residuals the of deviation standard the words, other In ili t y 9. 1.37 to 12 France sees volatility going from a low a from going Francevolatility sees to 0.71 ) for all countries with the exception the with countries all for 1999) 1.2; the us 49 ) ( show substantial reduction in policy , and Italy from Italy and 0.49, uk from 11

1.85 to eu countries in achiev- 0.9 Outside of the to 1.41 us 3.0 to , we see 0.41 0.51 1., 49 FISCAL POLICY 50 chapter 3 in oil prices. calculation because of the high volatility of the budget stemming from fluctuations for the rest of the countries. This trend can be the result of proactive towards less dispersion among the euro countries which is not evident Zealand, Sweden,Switzerland,the Zealand, measure for the non-euro countries. same the to it compares and countries euro across balance budget see a common economic policy. national business cycles and the desire of the European institutions to with deal to need the between tension natural a is there Soshocks. less coordinated fashion as it needs to deal with idiosyncratic national even an in behave should policy fiscal policy, monetary common a with that forget cannot we countries, euro the among policy fiscal ecb to increasing emphasis on the coordination of national fiscal policies. pretation and implementation of the Stability and Growth Pact has led solidation efforts for many of the governments. In addition, the inter- policies. For example, the run up to the euro launch led to fiscal con- fiscal national across commonalities some introduced possibly has of euro-wide fiscal policy is not entirely meaningless. The framework of the Maastricht Treaty and the Stability and Growth Pact, so the idea vidual policies have been designed within the institutional framework gregate – it is simply the collection of individual policies – these indi- Although there is no government behind the behavior of the euro ag- C bank to do its job. central the of ability the hurting or helping is policy fiscal whether the of perspective the adopt and area euro the of stabilization the consider we Second,if countries. other mon currency, there could be interest rate effects of fiscal policies in two reasons to look at coordination. First, as countries share a com- are There policy? fiscal euro a like anything there Is policies? these the national level. Have we seen any change towards coordination of In the previous sections we looked at the behavior of fiscal policy at Fiscal policy coordination oo 13. Figure Should coordination of fiscal policies be an objective? While the might be interested in seeing a common and countercyclical and common a seeing in interested be might h nner cutis r: utai, aaa Dnak Jpn New Japan, Denmark, Canada, Australia, are: countries non-euro The rdi plots the annual standard deviation of the structural the of deviation standard annual the plots 3.4 nat i on o f nat uk 50 ) ( i , and the and , l ona 13 Since ecb . Norway is excluded from this from excluded Norwayis us.

fi 1999, there is a clear trend , we need to investigate to need we , scal

p o li c ie s (standard deviation across countries in per cent). in per countries across deviation (standard D 3.4 Figure cilitated the task of the national level, but what about at the euro level? Has fiscal policy fa- the at policy fiscal of stance cyclical the at before Welooked have The early the that the dispersion of the result of synchronization of business cycles. Indeed, Figure close to or above the limits established for budget deficits. coordination but it could also be the outcome of some countries being the comparison of Figures for the euro area and for the group of the non-euro area countries. So convergence of national fiscal policies. a surprise, given the emphasis by the European Commission on the be not should This cycles. synchronizationbusiness the of just than countries there is more to the synchronization of fiscal policy stances given point in time. 18 15 12 0 6 9 3 19 14. The trend towards more similar structural balances may also be a 75 eur The 19 gdp 1990s. 79 o fi o -gap is the difference between the actual Eur o 14 ispersion of cyclically adjusted budget balances balances budget adjusted of cyclically ispersion sca 1983 Interestingly, however, this trend is visible both visible is trend this however, Interestingly, ecb l p 1987 gdp ? If we look at the way the structural budget o 3.4 and li -gap has been declining steadily since c 51 ) ( 1991 y stanc 3.5 indicates that within the euro 1995 e gdp Non-euro 1999 and its trend value at a 200 3.5 shows 3 200 7 51 FISCAL POLICY 52 chapter 3 li statistically significant. and pronounced more even becomes countercyclicality then gap, the of instead budget balance, so we are ignoring automatic stabilizers. emphasize that we are looking at the cyclicality of the even countercyclical fiscal policy for euro countries. It is important to these results contradict those in other papers that show a cyclical or that seem might It rates. growth increasing displayed economy the provement in the budget balance during a period (post-2003) where is clearly procyclical, given that in recent years we have seen an im- policy has remained as procyclical after euro area is an exception as it is one of most the procyclical few policies areas of or the countries countries where we consider. In addition, the D 3.5 Figure a procyclical manner. observe that the discretionary component of fiscal policy behaves in we cycle, business the over behaved has area euro the for balance cent). in per countries 10 0 4 cality of the fiscal policy stance in the euro area. If one includes real includes one If area. euro the in stance policy fiscal the of cality 6 8 2 16. 15. 19 To stance fiscal area euro the that surprising seem might it some 75 A regression of the primary balance on the output gap indicates count Fatás and Mihov (2009). 19 Non-eur 79 ispersion of G ispersion 1983 o 15 In fact, the euro area fiscal policy is among the 198 7 DP -gaps (standard deviation across across deviation (standard -gaps 52 ) ( 1991 Eur 1999 as it was before. 199 o 5 1999 cyclically adjusted 200 16

gdp 3 growth er 200 cyc 7 Fiscal policy stance and the G the and stance policy Fiscal 3.6 Figure levels of deficit that were too close to in caught were countries euro the of some First, improvement: this which again represents procyclical policy. There are two reasons for a negative union. After the recession of 1998 decrease in deficits to qualify for membership of the monetary policy after the launch of the euro, a sign of fatigue decreasing balances after after the strong pre- tive correlation. The evolution of the euro fiscal stance is marked by policy, for the euro area we see exactly the opposite, a strong nega- countercyclical strong signaling correlation positive clear a is there 3.7 does the same for the 2007. budget balance against the changethe plotted have we area, euro the adjusted cyclically the in fiscal policy stance (see (2007)). Change in CAB (per cent) 17. –0 –1 The difference between the two plots is shocking. While for the Figure To understand better the strong procyclicality of fiscal policy in policy fiscal of procyclicality strong Tothe better understand 0.0 0. 1. .0 .5 0 5 It is quite common in the literature to look at this graphical representation of the 17 –2

3.6 plots these two variables for the euro area and Figure gdp 2005 -gap, there is an improvement in the structural balance 2004 200 European Economy –1 3 us 2000, which reflect the relaxation of fiscal 2006 gdp . 2002–2003 and despite the existence of GDP-gap (perce 53 ) ( -gap for the years between 2008 or Alesina, Campante and Tabellini 200 01 3 per cent (or above 200 7 2 DP nt) -gap. 200 3 per cent) 2000 and 1 2000 2 us

53 FISCAL POLICY 54 chapter 3 policy. countercyclical mildly or acyclical signaling slope, positive a see we area euro the that dramatic. For the rates as an indicator of the cyclical position of the economy, the picture will not look of the years. of share a as suchprofits effects, in increase an as composition Someto normal. due than be larger could were this of governments expected. One interpretation is that the tax elasticities this is especially true in and they had little room to adjust their fiscal policies. In addition, and G the and stance policy Fiscal 3.7 Figure and it is likely that we will see similar behavior in the future. expected, as work not did framework policy fiscal the that feeling a effects of the launch of the new currency), but it is years also reveals difficultthat tosome avoid of it is due to special circumstances (such as the the cyclical condition of the economy. structural balance that remained too low, despite the improvement in crease in taxes that in the years that followed (2006 and governments to be permanent and led to increases in spending or de- Change in CAB (per cent) 19. 18. –4. –2. –2. 0.0 2. This reading of the behavior of fiscal policy during these eight these during policy fiscal of behavior the of reading This 0 0 0 0 gdp – We need to be very careful interpreting some of these See European results Economy because (2008). of the use 18 1.5 These increases in revenues and elasticities were assumed by -gap and the possibility that it is not measured properly. If we use growth 200 200 3 2 us there is still clear countercyclicality in fiscal policy but for 2005, tax revenues increased faster than many 2004 0 200 GDP-gap (perce 2005 200 1 54 ) ( 7 2006 DP nt) -gap. 1.5 gdp 2000 2007) led to a during these during 19 3 countercyclical after the introduction of the euro, as would be ex- be would as euro, the of introduction the after countercyclical countries in the sample, but the policy seems to have become more Overall, euro countries have more procyclical policies than the other countries. most in behavior countercyclical strong a see not do we national business cycles. When we look at discretionary fiscal policy, lizers built into their large governments and that these help to news stabilize is that European countries tend to have stronger automatic stabi- since the Maastricht Treaty. focus on sustainability that the European institutions have maintained conduct of monetary policy, which raises questions about the strong same time, this partial failure has not had any negative impact on the sustainability.long-term on impact major any had have debt At the euro was launched there is little evidence that the limits on euro launch deficitshad and a clearly positive impact on debt levels, but once the distinctly countercyclical after groups. One notable exception is the two these across difference much not is there that shows countries, three countries that opted out of the project, as well as other non-euro the performance of fiscal policy in the euro countries, relative to the etary union on fiscal policy have been fairly minor. The assessment of seen ten years of data, what have we learned? business cycles at a time when it was most needed. Now national that with we deal to have policy fiscal of ability the limit would straints con- these that argued who those were debate the of side other the from fiscal policy on the conduct of monetary policy by the of public finances and to avoid the possibility of negative influences Pact on deficits and debt. Their goal was to ensure the sustainability straints defined by the Maastricht Treaty and the Stability and Growth how fiscal policy has adapted to this new environment. Denmark and the ly by the three countries that opted out of the of single this currency: unique Sweden, experiment. The debate has been watched very careful- this period we have seen a debate about the successes and the failures The European monetary union was launched ten years ago and over C oncluding oncluding remarks When it comes to the cyclical behavior of fiscal policy, the good From the point of view of long-term sustainability, the run-up to the The evidence we present here suggests that the effects of the mon- The debate on fiscal policy has been focused around the strict con- uk. In this paper we have reviewed the evidence on 1999. 55 ) ( us , where fiscal policy turned ecb . On 55 FISCAL POLICY 56 chapter 3 policy over the business cycle. stabilizers and designing a proper framework for the conduct of fiscal a time when it should have been focused on strengthening automatic concepts of sustainability and coordination without much success, at tutional framework for fiscal policy – one that has been focused oncannot the ignore that these results also provide a picture of a failing insti- blame the monetary union for some of these policies. However, one lowed better policies than others. In that sense, it would not be have right seen to is linked to national decisions, and some countries have fol- countercyclical stance to stabilize business cycles. Much of what we terized by difficulties in reducing debt levels and providing a clearly siderable continuity in terms of less-than-ideal fiscal policies, charac- strong role during the first ten years of the euro. There has been con- European Economy (2008),»Public Financesin Monetary Union– Burnside, C.,M.Eichenbaum andJ.Fisher(2004 ), »AssessingtheEffects to the serve a clear procyclical policy both before and after stance of the euro-wide fiscal policy, the results are puzzling; we ob- lizing role that national monetary policy cannot play. countries, signaling that fiscal policy may not be taking over the stabi- pected. However, the change is small and does not appear in all euro Blanchard, O.andR.Perotti (2002),»AnEmpiricalCharacterizationof Blanchard, Olivier(1993),»SuggestionsforaNew Set ofFiscalIndica - Alesina, Alberto,FilipoCampanteandGuidoTabellini (2007),»Whyis R eferenc Overall, our findings suggest that fiscal policy has not played a played not has policy fiscal that suggest findings our Overall, 2008«, EuropeanCommission. 89–117. of FiscalShocks«, JournalofEconomicTheory,vol. 115(1), 2004,pages on Output«,QuarterlyJournalofEconomics,Vol. lxvii the DynamicEffectsofChangesinGovernment SpendingandTaxes Political EconomyofGovernmentDebt,ElsevierScience Publishers. tors«, inH.A.A.Verbon andF.A.A.M. van Winden (eds),TheNew Fiscal Policy oftenProcyclical«, Unpublished manuscript. When we adopt the perspective of the us where we see a policy that is clearly countercyclical. e s 56 ) ( ecb and look at the cyclical 1999, in contrast . Wyplosz, Charles(2005)»FiscalPolicy: InstitutionsVersus Rules«, Tornell, A.andP. Lane(1999),»TheVoracity Effect«, American Economic Statement oftheGoverning Council of the ecb Perry, G.(2002),»CanFiscalRules Help Reduce MacroeconomicVolatil - Mohr, M.andR.Morris (2007),»UncertaintyinMeasuring theUnderly- Melitz, Evidence Jacques(2000),»Some Cross-Country AboutFiscal Lane, PhilipR.,(2003),»TheCyclical Behavior ofFiscalPolicy: Evidence Kaminsky, Graciela,CarmenReinhart andCarlosA.Vegh (2004), Girouard, Nathalie andChristopheAndré(2005),»Measuring Galí, Jordi andRoberto Perotti (2003),»FiscalPolicy andMonetary Inte - Galí, Jordi (1994),»Government SizeandMacroeconomicStability«. Fatás, AntonioandIlianMihov(2009),»FiscalPolicy andtheEuro«,in Fatás, Antonio,andIlianMihov(2003),»TheCaseforRestricting Fiscal Fatás, AntonioandIlianMihov(2001b).»Government SizeandAuto- Fatás, AntonioandIlianMihov(2001a).»TheEffectofGovernment National InstituteEconomicReview191:70–84,January. Review, No. 89. Policy Research Working Papers, No. 3080. ity intheLatinAmericaandCaribbeanRegion?«, World Bank ing BudgetaryPosition andFiscalStance«,manuscript. Economy 2:3–21. Policy Behavior andConsequences formonetaryunion«,European from theoecd ic Policies«, nber »When itRainsPours: Procyclical CapitalFlowsandMacroeconom- Department Working Papers 434,oecd adjusted BudgetBalancesforoecd gration ineurope«,EconomicPolicy, Vol. 37,2003pp.533–572. European EconomicReview,38. Euro, nber Alberto AlesinaandFrancesco Giavazzi(eds.)TheFirstTen Years ofthe November. Policy Discretion«,QuarterlyJournalofEconomics,Vol. 118,Issue3 matic Stabilizers«,JournalofInternationalEconomics. manuscript. Spending onConsumption andEmployment:TheoryEvidence«, andUniversityofChicagoPress. «, JournalofPublicEconomics. Working Paper, No 10780. 57 ) ( Countries«, oecd Economics Department. , March 212005. Economics Cyclically 57 FISCAL POLICY chapter 4

FINANCIAL INTEGRATION

he monetary union has opened up the possibility of a fully integrated European financial market comparable to that of the United States. By eliminating exchange rate risk, it has eliminated a crucial obstacle to financial integration. Before the monetary union, otherwise identical financial claims denominated in different euro-area currencies were imperfect substitutes and traded at different prices. The monetary union has eliminated this source of market segmentation. Yet if a single currency is a necessary condition for the emergence of pan-European capital markets, it is not a sufficient one. Other fric- tions may still impede full integration: even after the removal of exchange rate risk, persistent differences in the regulations applying to financial intermediaries, tax treatment, standard contractual clauses and business conventions, issuance policy, security trading systems, settlement systems, availability of information, and judicial enforcement may still segment markets along national lines. In the process that preceded and accompanied the introduction of the euro, however, monetary unification also triggered a sequence of policy actions

( 58 ) in different areas within it. compare prices – or rates of return – for comparable securities issued measure the degree of financial integration of a region one needs to of the location of its bank. This definition immediately implies that to or household should be able to borrow on the same terms irrespective notion also extends to credit markets: when they are integrated, a This markets. both in capital for same the pay must it equity, raises firm pay the same interest rate to both sets of bondholders. Similarly, if it other words, if a firm issues bonds in two countries or regions, it must when securities with identical cash flows command the same price. In Financial markets are integrated when the law of one price holds, i.e. Financial integration and financialdevelopment future of European financial markets. more integrated and conclude with some policy implications for the Next,growth. become actually has area euro the whether assess we and how their removal should affect financial markets, and economic integration and consider how to measure it, analyze the barriers to it nance and real economic activity. To this purpose, we define financial the burgeoning literature on the complex links between regulation, fi- development, investment and growth? led to actual financial integration, with beneficial effects on financial ry barriers aside. To what extent has this process of regulatory reform and private sector responses that swept many of these other regulato- mediaries; similarly, judicial efficiency can differ across countries, re- countries, across differ can efficiency judicial similarly, mediaries; For instance, regulation can create stiffer entry barriers for foreign inter- intermediariescial competingfrom acrossbordersequalfooting. on a wedge between the after-tax cost of capital in different countries. to integration stems from differential taxes and subsidies, which drive will induce a deviation from international arbitrage. A second barrier exchange rate fluctuations, transaction costs for currency conversion security denominated in a foreign currency. And even if there are no a hold to premium risk a require will investors and risk, additional dictions have different currencies, exchange rate fluctuations create What can stand in the way of the law of one price? First, if two juris- Barrier This chapter seeks to answer this question in the broader context of Next, differences in regulation and enforcement can prevent finan- s to fi nanc i al 59 ) (

i nt egr at i on 59 FINANCIAL INTEGRATION 60 chapter 4 to foreign markets and intermediaries. fostered the growth of domestic financial markets or improved access also this services, financial for and funds for demand the stimulates ward and more heavily regulated. To the extent that greater efficiency of the euro-area countries where the financial system was more back- actions boosted efficiency in the financial intermediaries and markets the rules governing the issuance of public debt were harmonized. created a level playing field in the credit and securities markets, and capital flows were removed, banking and financial service directives er regulatory barriers to financial integration. For instance, controls on policy actions and private sector responses that swept aside many oth- sequence of monetaryunification triggered a toleadingprocess the removing one of the main barriers to financial integration. Inthe costs of addition,exchange rate transactions within the euro zone, directly knowledge to give local lenders an informational advantage. kets, where the opacity of firms and households combines with local and domestic incumbents. This is particularly relevant in credit mar- but from asymmetric information between potential foreign entrants dictions to compensate for expected recovery costs in case of default. quiring intermediaries to charge higher interest rates in inefficient juris- abundant credit and/or lower interest rates. competition, possibly coupled with cost cutting, translates into more also be associated with a decreasing cost of intermediation. Sharper will process the scale, efficient their to closer banks bring mergers If rents. banks’ local erode to likely are intermediaries of quisitions ac- cross-border and banks foreign by penetration Direct services. financial additional the supply may themselves entrants foreign the cial systems, and thus expands local financial markets. In some cases, for the firms and households of countries with less developed finan- This competitive pressure drives down the cost of financial services intermediaries. foreign lower-cost or sophisticated more with tition compe- increased is development financial domestic spur can tion The main channel through which the removal of barriers to integra- on The By eliminating some barriers to financial integration, these policy The introduction of the euro has eliminated exchange rate risk and constraints regulatory from not arise may barriers entry Finally, A second channel is through harmonization in national regula- national in harmonization through is channel second A fi effe nanc ct o ct i al f

devel i nt egr o pme 60 ) ( at i on nt

adopt the euro. not did that countries European five of group control a with countries euro eleven strained firms. there is evidence that the euro boosted investment by financially con- tion should also contribute to their growth and investment. Indeed, financial development in more backward countries, financial integra- promoting by that expect would one literature, this of basis the On with a causal relation running from financial development to growth. financial markets grow faster. Furthermore, the evidence is consistent cally in many studies, and it has been found that countries with better tivity of the economy will increase. from bad, funds will go to the more profitable projects andthat more sophisticated theintermediaries can distinguish produc- good projects opportunities that would otherwise be forgone. Second, to the extent nancial sector allows investors to fund profitable but risky investment the trading, hedging and pooling of risks, a more highly developed fi- efficiently.more capital allocating by facilitating growth by to First, the savings channeled to investment will increase. cheaper finance. As a result, the costs of intermediation will fall and and shareholders, encouraging them to provide more abundant and creditors of protection the enhance or barriers, entry removing by spurred by integration) may affect growth: two channels through which financial market reforms (such as those To put it simply, is there a »growth dividend« financialfrom phenomenon orthe also has effectseuro? on investmentThere and growth. are A natural question is whether financial integration has been a purely i F the supply of finance in less developed markets. of barriers to financial integration can bring about an improvement in more backward in countries. On both intermediaries accounts, therefore, the financial removal foreign of entry the and development financial domestic enhance also will it standards, international best the to convergence promotes harmonization regulatory that extent Torequires. the integration of process the which governance), rate tions (accounting standards, security laws, bank supervision, corpo- n i 1. nanc ve The thesis that finance matters for growth has been tested empiri- (2) Deeper and competitive financial markets can also contribute as intermediaries, between competition increase may They (1) ), who compare data from the original the from data compare who (2006 ), Nilsson and Koskinen Bris, See me st ia l nt an 1

i ntegr d

gr at o i w on, 61 ) ( th

61 FINANCIAL INTEGRATION 62 chapter 4 while the monetary union. This is especially evident for Denmark and Sweden, even for the inter-bank rates of countries that have not yet joined the reflecting the fact that the euro rate has acted as a powerful attractor non-monetary union countries decreased after the launch of the euro, etary union in mon- joined (Greece rate Euribor common the to converged rates and Portugal. After the launch of the euro, the euro-zone inter-bank pendent from that of the Sweden and the countries that have chosen not to join the monetary union (Denmark, bank rate from This is shown in the two graphs of Figure across the euro area converged fully to the benchmark Euribor rate. deposits inter-bank on rates interest union, monetary the of outset tion has been felt in the euro-area money markets. Almost from the The most immediate impact of monetary union on financial integra- Mon incomplete. still currently is and slowly more proceeded instead has integration markets credit especially and bond corporate equity, the rency.In cur- single the of adoption the with immediately almost integrated markets debt public the and markets money The markets. different in paces different at proceeded has Europe in integration Financial financialmarkets? How integrated are European France and the Netherlands already featured low spreads over Ger- Austria,Belgium,while PortugalSpain, Italy, and Ireland, Finland, from the convergence of the non-core monetary union participants: to September tively similar patterns obtain for other maturities) from January lustrated in Figure on national public debt on the eve of monetary unification. This is il- yields the of convergence dramatic a produced also changes tional institu- concomitant the with union monetary of combination The Bon Most of the action came before the launch of the euro and derived d ey

marke

uk m a ’s monetary policy has apparently remained more inde- 2007. The convergence is dramatic. 2000 and is not reported). The interest rates of the three tsrke 1990 to uk ts 4.2 for the ). Before 2007 in euro-area countries and in the three ecb 1999, the highest spreads existed in Italy . 10-year benchmark bonds (and qualita- 62 ) ( 4.1, where we plot the inter-

1993 eu

S rates. interbank 3-month 4.1 Figure ource:

Datastream. 3-month interbank rate 3-month interbank rate 20 20 25 25 10 10 15 15 0 0 5 5 1990 1990 UK Denmark 1992 1992 1994 1994 Portugal Italy German Finland Austria 1996 1996 y 63 ) ( 1998 1998 2000 2000 Euro Sw eden ar 2002 2002 ea av Spain Netherlands Ir Fr Belgium eland anc 2004 2004 er e age 2006 2006 2008 2008 63 FINANCIAL INTEGRATION 64 chapter 4 S yields. bond benchmark 10-year 4.2 Figure ource:

Datastream. 10-year bond yield 10-year bond yield 10 10 15 15 0 0 5 5 1990 1990 1992 1992 UK Denmark 1994 1994 Portugal Italy German Finland Austri 1996 1996 a y 64 ) ( 1998 1998 2000 2000 Euro Sw eden 2002 2002 -zone av 2004 2004 Spain Netherlands Ir Fr Belgium eland anc er age 2006 2006 e 2008 2008 spreads than comparable sterling- and dollar-denominated bonds. bid/ask narrower have bonds corporate Euro-area market. the of ity the true success story of monetary union is confirmeddevelopment byof an theactive greateuro-denominated corporate liquid- bond market is umes more than doubled, from $273 billion to $657 billion. That the in issuance bond corporate soaring promoted euro man bonds in the first set of countries, but not in the second. second. the in non-core not the but For countries, of set first the in considerable was D-Mark the to relative depreciation of ability tion. in the covariance of ex-post returns do not necessarily reflect integra- common European shocks since the early show that European stock returns have increasingly been driven by est rates, should become more closely correlated. The evidence inter- does like returns, market stock integrate, to start markets mented seg- when that posits approach common most The markets. bond for than difficult more is euro the of introduction the since tegrated in- more become have markets stock European whether Assessing S and pension funds decreased after the introduction of the euro. ficiently into foreign stocks. But the home bias ofdence euro-areafor investment the »home equity bias«, i.e. investors’ failure to diversify such suf- as the composition of financial portfolios. There is abundant evi- by definition monetary policy has now become common. the common component of real shocks across countries, and where the integration of goods and labor markets is likely to have increased monetary policy). This point is particularly relevant for or say, the prices, (oil shocks same the by hit increasingly are markets achieved a remarkable degree of integration. ally remained higher. yields converged to the euro-area average, while in the almost entirely to the elimination of this risk. In Sweden countries, and the drastic Denmark narrowing of the toc 5. 4. 3. 2. Other tests of stock market integration rely on quantity indicators, The analysis of corporate bonds shows that also this market has has market this also that shows bonds corporate of analysis The See Adam et al. (2002) and Baele et al. (2004). See Baele (2005). See Biais et al. (2006 ). See Baele et al. (2004 ). 4 Market returns may exhibit common patterns simply because k

marke 1996. This is because before monetary union the prob- ts 65 ) ( 10-year yield spreads was due 1980s, but these changes 2

The introduction of the , when vol- when 1999, uk they gener- eu , where 5

65 FINANCIAL INTEGRATION 66 chapter 4 to which we shall return. from the fragmentation of the clearing and settlement system – a remain, point notably the considerable costs for cross-border trades arising integration. However, significant institutional barriers to integration factors was to limit consolidation among euro-area banks. systems could become foreign-owned. The cumulative effect of these banking domestic their of parts substantial that possibility the limit authorities for the idea of creating national champions, as a means to countries. Finally, there may have been tacit support among national domestic level before venturing into acquisitions in other euro-area more difficult. Second, banks wanted to acquire sufficient size at the regulation, taxation and labor laws made cross-border consolidation interest rate differentials remain wider than in the bond market. local nature of the information that lenders need. As a consequence, kets, presumably because of the heterogeneity of borrowers and the mar- bond than slowly more much integrated have markets Credit Credi osldto aog uoae banks. euro-area among consolidation domestic for preference the explain that factors three cites mission Com - European the by report recent A years. recent over creased tic banking systems of euro-area member countries have slightly in- Accordingly,domes- existence. the into within ratios concentration came groups bancassurance several as consolidation, cross-border than consolidation cross-sector of examples more were there deed, In- borders. national within exclusively almost occurred sector ing national pools of borrowers. nancial integration in this market, or different risk composition of the fi- to barriers persistent either reflect may This countries. non-euro the in than gence from rate market mortgage the the mortgage market. This is exemplified in Figure term corporate loan market, in the consumer credit segment and in particular, there are persistent differentials in the medium- and long- 7. 6. Thus for equity markets too there is some evidence of increasing Meanwhile the initial wave of consolidation in the euro-area bank- European Commission (2008). See Adam et al. (2002) and Baele et al. (2004). t marke -year government bond rate, in both euro and euro both in rate, bond government 10-year ts 66 ) ( to 1996 7 is, ares eaig to relating barriers First, ; there is less conver- less is there 2005; 4.3, which plots 6 In S Mortgage rates.4.3 Figure ource: ource: Hypostat Mortgage rate Mortgage rate 10 10 12 4 6 4 8 6 8 2 2 1996 1996 , E uropean Mortgage Federation, various issues. various Federation, Mortgage uropean UK Denmark 1998 1998 Portugal Italy German Finland Austri a 2000 2000 y 67 ) ( 2002 2002 Euro Sw eden Spain Netherlands Ir Fr Belgium ar eland anc ea av e 2004 2004 er age 2006 2006 67 FINANCIAL INTEGRATION 68 chapter 4 partly as a result of the financial crisis. gian-based Fortis Bank in of the the acquisition of the Netherlands-based of HypoVereinsbank in Germany by the Italian Unicredit Group, more and common: among the more notable examples is the acquisition tum, as cross-border banking mergers and acquisitions have become in corporate bond markets. government bond markets, and (4) the poor post-trade transparency of issuance fragmented the (3) exchanges; stock many too among infrastructure trading the of fragmentation the (2) system, tlement set- and clearing the of segmentation the (1) are markets securities uneven pace of integration in security markets and bank lending. will differ depending on which market is involved, in keeping with market participants the alone from now onwards? Arguably, the answer tion. In other words, can financial integration be safely entrusted to and (2) to cope with some of the undesired effects of financial integra- regulatory intervention is required (1) to remove remaining obstacles pected to continue spontaneously and smoothly, or whether further ex- be should process the whether ask to natural is it So complete. from far is integration decades, two past the in Europe within pace Although financial integration has proceeded at a remarkably rapid Prospects for securities market integration overcoming this problem is likely to require regulatory action at the the incumbent’s post-trade clearing and settlement system. use to have still would customers entrants’ new since platforms, ing services (»silo structure«). This limits the post-trading competition corresponding from the other for system trad- settlement and clearing proprietary a and services trading provide to platform a both with exchanges, such as Deutsche Börse, in fact, are vertically integrated, partly on the persistent fragmentation of depends stockSegmentation trades. cross-border for trading costs high properly platforms. Some im- entails system settlement and clearing the of segmentation The Cle But in recent years credit market integration is gaining momen- gaining is integration market credit years recent in But The four main remaining obstacles to the integration of euro-area Entry foreclosure generates rents for incumbent exchanges,and incumbent for rents generates foreclosure Entry a uk ri -based Royal Bank of Scotland, Banco Santander and Bel- n g an d s e tt 2007. Many more have taken place since, leme 68 ) ( nt abn

amro by a consortium stock exchanges merged into Euronext; Stockholm’s pushed for consolidation: the Paris, Amsterdam, Brussels and Lisbon have exchanges existing thing, one For reduced. being necessarily changes and financial intermediaries, although fragmentation is not ex- of initiative the at lines transnational along restructured being pean stock markets – once organized on a national basis – is already Euro- of infrastructure trading the settlement, and clearing Unlike Stoc eu issue size than in the smaller and issuers many with fragmentation, greater to due is gap government bond markets as well. In the euro-area in integration towards progress further for room is There Go created as a direct result of government pressure. was that company service Corporation,user-owned Clearing a and both clearing and settlement are the product of the Depository Trust us institution to provide central clearing and settlement services. In the »Target ability of going into the settlement business itself, with a system called ecb cal authorities. Some progress might be made by limiting joint issu- fis- national independent with conflicts create may which issuance, debt joint of problem thorny politically tacklethe should ernments cantly higher than in the signifi- are spreads) bid/ask effective (median costs trading bonds, dency is towards pan-European, not national trading platforms. are consolidated, new ones are being instituted; in both cases the ten- new pan-European equities trading platform. So, as existing platforms a consortium of seven top investment banks has already launched a and intermediaries, by operated platforms trading new of creation Financial Instruments Directive (m Meanwhile,the Italiana. Borsa Exchangeacquired Iceland, Estonia, Lithuania and Latvia; and in exchangesoperates now Sweden,and in quired Denmark,Finland, 8. , the Federal Reserve Board runs a bond settlement business, and level. This is recognized both by the ver , which announced in July See Dunne, Moore and Portes (2006). k Securities« (t2s Securities« 2 t nme r a nt di n b g us. ond

i 8 n us To overcome fragmentation, euro-area gov- fr ). The ). Treasury market. This persistent liquidity

i ss ast 2006 that it was considering the desir - 69 ) ( u ecb anc ru i fid would not be the first public first the be not would ct ) has opened the door to the e eu mts ure Commission and by the 2007 the London Stock platform for euro-area eu omx ’s Markets in Markets ’s

ab has ac- 69 FINANCIAL INTEGRATION 70 chapter 4 small institutions. small European corporate bond market, especially for retail investors and ied in prices much more slowly. mation about fundamentals that their orders could convey is embod- transparency«, investors hesitate to place orders, and the new infor- ing« and guide to trading strategy. In the absence of such »post-trade trades effected becomes an essential sign of »where the market is go- investors, in such a decentralized market information on prices of the most orders are still routed to brokers and dealers by telephone. For emerge, to starting now are platforms trading electronic Although ers satisfy customers’ sell and buy orders at their bid and ask quotes. ized as an liquidity of the market. is likely to speed up the price discovery process and to increase the reflected in market prices. Some increase in post-trade transparency takes more than a day for the information content of a trade to be fully As in the Tr bond issuance. magnitude of the liquidity gains and debt servicing savings from joint ance to just a few maturities, at least initially, so as to test the potential may help to dismantle the remaining national barriers to entry in the way.under enforcement However,and changes regulation some in getting now is that process a – subsidiaries them making and banks local customers can be attenuated by foreign banks taking over local about information lackof the though even soon, disappear not will credit cross-border to and lenders foreign of entry the to obstacles and on the enforceability of contracts in national jurisdictions. These lending, which depends on local and customer-specific information of nature intrinsic the to due probably is integration financial pean Euro- of process the in laggard the been has market credit the That Prospects for credit market integration corp 10. 9. Currently there is no systematic post-trade transparency in the in transparency post-trade systematic no is there Currently ans See Biais et al. (2006 ). See Biais et al. (2006 ). or us p otc a at , the euro-area corporate bond markets are mainly organ- re dealer market, where trading is decentralized and deal- e nc

b 9 As a result, price discovery is very slow: it often it slow: very is discovery price result, a As on y i 10 d n t n

m a he rke

70 ) (

t its solution is not something that we can expect to happen swiftly. nitude of the problem goes far beyond credit market integration, and to the best bringing judicial enforcement in the more backward jurisdictions up credit access for firms in the most inefficient jurisdictions. Of course, where cross-border lending may become increasingly common. situation a in safely, lend so and accurately risk default estimate to records on a supranational basis is also necessary for banks to be able of the euro area will not be integrated. Consolidation of customer debt foreign just as they are to domestic lenders, the national repaymentcredit marketsrecord and current debt exposure are available to different potential countries. Unless data on would-be borrowers’applicants must become available on a comparable basis to banks in characteristics, sharing. correlation between the ratio of private debt to degree of creditor protection and that there is a positive cross-country since the efficiency and honesty of the judiciary determines the real market, credit the of development the to essential is enforcement contract effective and speedy that suggests literature burgeoning A Loan contr eu private sector credit to sharing is broader and more solidly established, and that the ratio of private sector is greater and default rates are the lower to lending where bank that shows information literature Recent markets. credit in or »credit reporting« systems between banks play an important role arrangements sharing information that shown has research Recent In area. country differences in enforcement efficiency – even within the euro law«. Recent studies have demonstrated that there are dramatic cross- intervention on at least four distinct fronts. Credit market integration would benefit from further 12. 11. credit market and to reduce the risks of cross-border integration. f Differences in the length and cost of enforcement are a barrier to For credit markets to integrate cross-border, information on loan Forloan on information cross-border, integrate to markets credit o 11 Jappelli and Pagano (2002) and Djankov, McLiesh and Shleifer (2007). See Djankov, La Porta and Lopez-de-Silanes (2003).

atrm 12 eu standards is a huge task for national legislators. The mag- i on s act hari gdp e n f is positively correlated with information n o g r 71 ) ( s c y eme st em nt s gdp and the »rule of eu regulatory 71 FINANCIAL INTEGRATION 72 chapter 4 market integration. interlink their databases could produce substantial benefits for credit cies that manage public credit registries in Europe to harmonize and tions and privacy laws. On this front, concerted action by the agen- at these banks’ own initiative) and reflect a range of national regula- credit bureaus were created to serve domestic banks and (and sometimes registers Today’scredit national. predominantly still are area (2008). Another often overlooked difference in D measures of bank risk. on contingent rates make others deposits, to proportion in rates flat the prefunded schemes the premium structure also differs: some use actually fails; still others combine the two mechanisms. Moreover, in are prepaid into a fund), while others are funded ex post, once a bank ture. Some are prefunded (the amounts due in case of a bank failure struc- funding in differ also schemes insurance Deposit depositors. coverage countries may give banks lower incentives to protect their ticated and able to exert some market discipline on banks, the high- and in funding. Since larger depositors are more likely to be sophis- border, though subject to differing rules on deposit insurance. tail deposits, which are still small-scale, but banks that compete cross- guarantee deposit schemes. involves markets banking of segmentation the heightens pervision. cern for financial regulators in Europe today, namely prudential su- This leads us to the fourth – and certainly the most important – con- to deal with threats to the stability of the European banking system. of convergence between deposit insurance schemes would also help different countries and can thus affect competition. A certain degree posit insurance generates different incentives and costs for banks in (the available funds divided by the volume of deposits covered), de- 13. ep Unfortunately, the information-sharing arrangements in the euro Due to the implied differences across the Deposit insurance differs from country to country both in coverage os On this important point we draw largely on the insightful remarks of Trichet i t gu a r 13 ant The problem does not involve cross-border re- ee sc 72 ) ( heme eu s national regulations that eu in »coverage ratios« an eu fragmented current the of shortcomings the highlighted vividly has welcome effects as the risk of financial contagion. The financial crisis reaping the benefits of financial integration while avoiding such un- to key the is system banking European the of stability Securingthe Prude Even the among place taken have to appear meetings gency fidential information, no coordinated communication and no emer- con- of sharing no situation, the of analysis common no contagion, action would be essential. could actually exacerbate the crisis, when instead swift, coordinated Uncoordinated actions by the various national supervisory agencies ies, the rules for crisis management and burden-sharing are unclear. to have solvency problems at home or at one of its foreign subsidiar- were bank pan-European a Forif market. instance, credit the of ity ized along national lines, which entails considerable risk for the stabil- banks, prudential regulation and supervision are still mainly organ- tions for such a contingency. the market turmoil, but this is obviously no excuse by affected to severely been neglect have operations prepara- cross-border substantial tral banks.« cen- national to available normally counterparties of soundness the of crises involving pan-European banks and mitigate their effects. enforcement structure that would be needed to reduce the likelihood dential regulation is still removed from the uniform framework and banking crises involving joint responsibilities. However, the of event the in coordination strengthen to understanding« of dums These agencies have reached a whole series of bilateral »memoran- (cebs Supervisors Banking CommitteeEuropean the of agencies, common advisory body grouping all European banking supervisory Financial Services Action Plan of the with regulations financial harmonized largely has Commission 14. banking supervisory system. »Even with signs of a clear risk of risk clear a of signs with »Even system. supervisory banking Admittedly, major regulatory progress has been made. The made. been has progress regulatory major Admittedly, The problem is that despite the emergence of a few pan-European d See Padoa-Schioppa (2007).

b an nt ecb 14 ki i Luckily, so far no major , unlike the Federal Reserve, lacked the information on a n l g

regul supervi at i 73 ) ( s on i 1999, and in on

eu -based banking groups with 2004 it established a eu supervisors. eu pru- eu ).

73 FINANCIAL INTEGRATION 74 chapter 4 Djankov, Simeon,CaraleeMcLieshandAndreiShleifer( 2007), »Pri- Djankov, Simeon,RafaelLaPorta, FlorencioLopez-de-Silanes, and Bris, Arturo,YrjoKoskinen andMattiasNilsson (2006),»Therealeffects Biais, Bruno,Fany Declerck, James Dow, Richard Portes andErnst-Lud- Baele, Lieven,AnnalisaFerrando, Peter Hördhal, ElizavetaKrylovaand Baele, Lieven(2005),»Volatility SpilloverEffectsinEuropeanEquity Adam, Klaus,Tullio Jappelli,AnnamariaMenichini, MarioPadula and R markets. date financial integration and enhance the future stability of financial The chapter also highlights further steps that are required to consoli- assesses whether the euro area has actually become more integrated. and growth, and investment markets, financial on removal their of to measure it, analyzes the barriers that can prevent it and the effects how and integration financial defining by starts It union. monetary tegration has promoted financial development after the inception of This chapter provides an account of how the process of financial in- S eferenc ummary 299–329. vate Creditin129Countries«, Journal ofFinancialEconomics84(2), 453–517. Andrei Shleifer(2003),»Courts«, QuarterlyJournalofEconomics 118(2), 10(1), –37. of theEuro:evidencefromcorporateinvestments«,ReviewFinance ency, Liquidity,Efficiency,cepr wig vonThadden(2006),European Corporate BondMarkets:Transpar - Area«, ecb Cyril Monnet (2004),»Measuring FinancialIntegrationintheEuro Markets«, JournalofFinancialandQuantitativeAnalysis 40(2),373–401. index_en.htm January, http://ec.europa.eu/internal_market/economic-reports/ the EuropeanCommission, DirectorateGeneral forInternalAffairs, of CapitalMarketIntegrationintheEuropeanUnion«,Report to Indicators andMonitoring Methodologies toMeasure theEvolution Marco Pagano (2002),»Analyze,Compare, andApplyAlternative OccasionalPaper SeriesNo. 14. e s Report, May. 74 ) ( Trichet, (2008),»Keynote speech Jean-Claude attheSecond Symposium Stulz, René (1999),»GlobalizationofEquityMarketsandtheCost of Pagano, MarcoandErnst-LudwigvonThadden(2004),»TheEuropean Padoa-Schioppa, Tommaso (2007),»EuropeNeeds aSingleFinancial Jappelli, Tullio, andMarcoPagano (2002),»InformationSharing,Lend- European Commission (2008),emu Dunne, Peter, Michael Moore andRichard Portes (2006),European- Gov ecb.int/press/key/date/2008/html/sp080213_2.en.html Integration inEurope’«,13February, Frankfurt amMain,http://www. of theecb Capital«, JournalofApplied Corporate Finance12(3),Fall, 8–25. 20(4), 531–554. Bond Marketsundermonetaryunion«,OxfordReviewofEconomicPolicy Rulebook«, FinancialTimes, 11December, 13. Finance 26(10),2017–45. Evidence«,ing andDefaults: Cross-Country JournalofBankingand 10 Years ofEconomic andMonetary Union,European 2. Economy May. ernment BondMarkets:Transparency, Liquidity,Efficiency,cepr -cfs research networkon‘CapitalMarketsandFinancial 75 ) ( @10. SuccessesandChallengesafter Report, 75 FINANCIAL INTEGRATION chapter 5

TRADE AND INVESTMENT

o st st u di e s of euro effects on trade indicate that the euro has caused a significant and economically substantial increase of trade within the euro area and also – albeit to a lesser extent – between the euro area and outside countries. In contrast, studies of euro effects on foreign direct investment do not yield as clear results. Some indicate substantial and positive effects, others reveal no effects within the euro area. The euro seems, however, to have caused an increase in the inflow of investments. It was by no means obvious before 1999 that the common currency would have substantial positive effects on trade. Currency barriers to trade seem insignificant, and trade seems to be little affected by exchange rate fluctuations. We will review the evidence of euro effects. In addition we estimate the extent to which trade for Sweden, Denmark and the uk would increase, were they to join the currency union.

( 76 ) a maximum of one year. engender. It is possible to hedge against these, but normally only for and investment. Rather, it is the uncertainty that currency fluctuations trade international to barrier main the constitute that costs tangible exporting, importing or investing in a foreign country. therefore represent an important cost element in any decision to start will rates exchange in Uncertainty investment. and trade of ability profit- the consequently, and, costs and revenues affect eventually estimated the total cost to be approximately the value of exports and imports. and handling different currencies should not exceed one percent of exchanging,hedging of cost total The currencies. different with ing Further, for exporters and importers there are internal costs for deal- value. transaction the of percentage a as spread the to equal mately approxi- is currencies hedge and exchange to need the eliminating Swedishthe is and krona between buy and sell rates on the forward market between the euro changes in exchange rates until payment is due. The current spread against insuring of cost additional the accept will importers and ers between the euro and the Swedish krona is rent spread between the banks’ commercial buy and sell spot rates as rency exchange, but this cost is relatively small. Forcur- of cost example, the is the barrier obvious cur- most The investment? and trade to barrier a constitute currencies national different do way what In barriers to trade and investment? What are the currency-related the monetary union before and after its start in of members eleven original the between trade in development the Figure in line blue The analysis. statistical any been ing be useful to look at the picture that the data paints without there hav- Before considering the evidence of the euro’s impact on trade, it could without statistical analysis What the data implies 2. 1. Most practitioners will claim that it is not these relatively small, relatively these not is it that claim will practitioners Most Hedging for longer periods is possible, but much more costly. the on commission government Swedish The 2 Trends that persist for more than a year will percent. The social cost saved by saved cost social The percent. 0.4–5 77 ) (

1 0.2 per cent of 0.3 percent. Most export-

emu 1999 gdp (Calmfors et al., et (Calmfors . relative to trade shows 5.1 1997) 77 TRADE AND INVESTMENT 78 chapter 5 and outside countries relative to trade between the countries in the in countries the between trade to relative countries outside and lateral unidirectional trade between members of the currency union lowed by a more or less steady increase. we can see, there is a marked upward jump in trade around total trade increased within the currency union due to the common currency? analysis using weighted observations would answer the question: by how much has to increase between the average pair of countries in the currency union? Statistical usually answers the question: by how much has the common currency caused trade trade flows are given the same weight in the statistical analysis. Thetrade-weighted statisticalaverage, analysis but have chosen an unweighted average, we since only have unidirectional therefore forced to do the same for the whole period under investigation. Therefore, until statistics trade the in country one as treated were embourg average of monetary-union trade is indexed at intra- the of volume The countries. outside ten of group a between S T 5.1 Figure seven other consists of the three Zealand. oecd 100 140 130 120 110 ource: ource: Flam and 90 4. 3. 199 The red and yellow lines in the figure show the development of bi- The three Eleven countries yield countries are Norway, Switzerland, Canada, the 59 69 90 bilateral, unidirectional trade flows. = 90 9= trade 10 · flows within the currency union. We could also use a oecd eu N ordström (2007). ordström members are Denmark, Sweden and the 79 rade relative to a control group. control a to relative rade countries in Europe and the rest of the world. eu 89 members that were still outside at the time and = 110 10= trade 11 · flows. However, Belgium and Lux- 9 2000 Wi 78 ) ( thin euro 100 in 01 ar 1995 and is an unweighted 02 ea Fr us om euro To , Japan, Australia and New euro 03 uk 3 The control group , and the seven other ar ar 04 ea and we are we and 1999 ea 05 1999, fol - 06 4 As by receiving countries. incoming than of outgoing investments. Figure the exception. There is reason to believe that countries than are rather better rule at the are keeping countries track receiving the of and sending the by reported data between discrepancies big However, it. receiving country the and investment the making country the by reported are data stock and flow Both depreciation. investment after direct foreign accumulated of value the showing stocks of and year, data The unreported. comes both in goes the form of flows showing the value investment of foreign direct investment per direct foreign much that seems It trade. outside countries. which means that they grew at about the same rate as trade between period, whole the during flat less or more are however, countries, within the currency union. Relative exports from outside to member side countries exhibit a pattern around Figure after and before indicated by the yellow line in Figure is what to contrary area, euro the to countries outside from exports the statistical analysis in fact shows that the euro has caused increased tempts to do. The importance of this point is illustrated by the must fact be isolated that from other effects. This is what statistical analysis at- reductions. To ascribe the impact of the common currency, its effect Roundtariff Uruguay the and Market Inner the of implementation mon currency, such as com- the from apart factors other many of product a are data trade however.The certain, Webe countries. cannot outside to member from exports in as well as union currency the of members between troduction of the euro in is no clear trend in any of the three categories, namely of bilateral, of namely categories, three the of any in trend clear no is was unaffected by the start-up of the currency union in direction is trade flows. of average unweighted an is line Each countries and the yellow line shows exports in the opposite direction. outside to member from exports shows line red The group. control 6. 5. It is tempting to conclude from the data in Figure Figure The impression left by Figure Data on foreign direct investment is much less reliable than data on foreign on data than reliable less much is investment direct foreign on Data The number of trade flows between members and outside countries in each in countries outside and members between flows trade of number The 5.1 100. 10= 10 · shows the development of foreign direct investment direct foreign of development the shows 5.2 6 5

We can see that the relative exports from member to out- in analogy with the development of trade in trade of development the with analogy in 1999 gdp 1999 caused a substantial increase in trade fluctuations, exchange rate movements, 79 ) ( 5.2 is that foreign direct investment 5.1 1999, similar to that for trade 5.2 is based on stock data reported bilateral, unidirectional bilateral, 100 5.1 that the in- 1999. There 79 TRADE AND INVESTMENT 80 chapter 5 and Heckscher-Ohlin-Chamberlin models. with standard models of international trade, namely the Ricardian, Heckscher-Ohlin trade as derived by Anderson and van Wincoop (2003). The gravity model is consistent F 5.2 Figure for estimating its size. its estimating for and trade international affect to known are that factors other from impact this isolating for procedure statistical and model theoretical same the use trade on euro the of impact the of studies all Almost effects ofthe euro on trade T impact from the euro. trade, it is clear that we have to turn to statistical analysis to reveal Here,investment. direct foreign unidirectional of case the in unlike any particular kind of treatment that a common currency represents. In that have retained their national currencies, i.e. have not received the treated with a new drug. They are compared to a group of countries adopted the euro can be likened to a group of patients who have been clinical trials of medical treatment. The group of countries that have he he method for uncovering the 7. Index (100 = 1995) 100 140 160 120 The theoretical model is a variant of the so-called gravity model of international 40 60 80 20 199 59 69 Wi thin euro relative to a control group. to DI group. relative a control 79 7 89 The statistical procedure is the same as for as same the is procedure statistical The ar ea 9 2000 80 ) ( 01 02 To euro

03 ar euro Fr om ea 04 ar ea 05 06 fairly rich other way round. trade and investment to currency union participation, rather than the currency union. In other words, there is a risk that causality goes from were on the increase were just those who chose to participate in the it is possible that those countries whose mutual trade and investment fects of the euro on international trade and investment. In principle, ef- the estimating to comes it when problem a is non-participation union). The non-random selection of countries for participation and currency the in participation for ineligible are therefore and Union also why some countries have chosen not to be part of the European in union currency the there are economic and political reasons why some countries joined treatment«; »euro of case the in possible not is this Naturally, tics. characteris- group in differences initial no are there that ensure to the control group can be made randomly and in sufficient numbers in individuals and individuals treated of selection the trials, clinical trade between them at the expense of their trade with outsiders. removal of a trade barrier between some countries would increase the tive effect on trade between euro and non-euro countries, and that the countries. There is reason to expect that the euro would have a nega- tween euro and non-euro countries as against trade between non-euro procedure, some studies have also estimated euro effects on trade be- we have found the euro effect and identified its size. Using the same differences is sufficiently large statistically speaking, we assume that euro area and trade between the countries outside. If the sumed difference-in- to depend on the different effect of the euro on trade two within differences the is then calculated. This difference-in-differences is as- these between difference The group. control the in countries tween be- trade for and area euro the within trade for calculated are 1999 after and before trade of level the in differences The removed. also over time, such as geographical distance and cultural similarity, are constant be to thought are that factors on depend that pair country change rates and tariffs. Differences in the level of trade between each are removed from the trade data. Such factors include 1999. Changes in trade that are caused by factors other than the euro The procedure is to select a control group of countries, usually countries, of group control a select to is procedure The oecd countries, and one time period before and one after and some chose to stay outside it (and it outside stay to chose some and 1999 81 ) ( gdp , real ex- 81 TRADE AND INVESTMENT 82 chapter 5 Tabl beit not as large – on trade between euro and non-euro countries. surprisingly, most also find positive and substantial euro effects – al- their main results. Table Euro effectson trade: whatthe studies say * Based on industry * level on observations Based industry from the euro effect in the statistical analysis. The trend may include than the euro. euro effect in most of the studies is a trend that is due to factors other ing remains of the euro effect. They argue that what is interpreted as a when this trend is accounted for that show to in claim they the and countries, statistical euro the analysis, between trade ing little or noth- positive effects. 8. Baldwin, Baldwin, A M Barr, Barr, Baldwin, C Bun, Flam, Flam, Flam, Faruqee, D Berger, Frankel, J. Frankel, (2008) Gomes, Gomes, Brouwer, J., Three of the studies in Table Most studies find positive and substantial euro effects. Somewhat The fact that such a trend does exist makes it difficult to separate it hintrakarn, hintrakarn, uthor(s) e icco, icco, J. J. Bun and Klaassen ( 2007), Berger and Nitsch 2008) ( and Gomes et al. ( 2006). N M 5.1 provides a list of known studies of euro effects on trade and ardis, ardis, T E 5.1 M D H H urrey urrey and L. . , F. and Breedon . and F. (2007) Klaassen A . and . and H T ., ., R R ., ., H . and V. E ., ., F. . et. al. (2008) C S . (2004) . R . and S . Graham, . J. Graham, H H P tein tein and G. . . (2008) S . . P N N he euro effects on trade: on trade: effects he euro kuderlny and kuderlny 8 aap aap and J.- They show that there is a long-term trend for increas- N ordström ordström (2007) ordström (2003) C S itsch itsch (2008) . Vicarelli . (2003) Vicarelli chembri (2006) chembri D H O . elliwell, elliwell, rdoñez rdoñez (2003) M M iles iles (2003) . Viaene . (2007) Viaene D . T (2006)* aglioni T . Kano, 82 ) ( 5.1 question the findings regarding O verview of research results. of research verview 1990–2006 1990–2004 1980–2003 1980–2000 1948–2006 1948–2003 1994–2002 1989–2002

P 1995–2006 1992–2002 1992–2002 1967–2002 1978–2002 1991–2002 eriod

P P P C P P P P D P P P P P anel anel anel anel anel anel anel anel anel anel anel anel ross-section ynamic ynamic panel ethod R Within Within euro area

9–13 9–13 % 0–22 0–22 % 2% % 26–83 3% 9–14 9–14 % 15% 14% 2–6 % 0–15 % 0–15 29% 28% 12–200 12–200 % 0% esults

and non-euro area and non-euro Between euro Between 1–9 1–9 % [not estimated] 0–1 0–1 % 22–24 % N [not estimated] 8% 8% [not estimated] M [not estimated] 12–14 12–14 % [not estimated] [not estimated] o trade diversion ixed ixed results

* Based on industry * level on observations Based industry Tabl Baldwin, Baldwin, A Barr, Barr, Baldwin, M C Bun, D Faruqee, Faruqee, Flam, Flam, Berger, Flam, Flam, Brouwer, Brouwer, J., Gomes, Gomes, J. Frankel, (2008) hintrakarn, hintrakarn, uthor(s) e icco, icco, J. J. N M ardis, ardis, T E 5.1 M D H H urrey urrey and L. . , F. and Breedon . and F. (2007) Klaassen A . and . and H T ., ., R R ., ., H . and V. E ., ., F. . et. al. (2008) C S . (2004) . R . and S . Graham, . J. Graham, H H P tein tein and G. . . (2008) S . . P N N he euro effects on trade: on trade: effects he euro kuderlny and kuderlny aap aap and J.- N ordström ordström (2003) ordström ordström (2007) C S itsch itsch (2008) . Vicarelli . (2003) Vicarelli chembri (2006) chembri D H O . elliwell, elliwell, rdoñez rdoñez (2003) M M iles iles (2003) . Viaene . (2007) Viaene D . T (2006)* aglioni T . Kano, O verview of research results. of research verview 1990–2006 1990–2004 1980–2003 1980–2000 1948–2003 1948–2006 1994–2002 1989–2002

P 1995–2006 1992–2002 1992–2002 1967–2002 1978–2002 1991–2002 eriod ket in the reductions in the strengthen European economic integration. Examples could be tariff fied as a trend which, in turn, is caused by earlier policy measures to effect may mean that what is really a euro effect is mistakenly identi- 1990s. Introducing this trend into the period used to estimate the iffs in euro the tar- eliminating suchas Union, European the by adopted measures policy on degree some to depend to likely is union currency the of for higher-than-average growth in trade between the initial members trend long-term difficulty. The inherent own its has so doing ever, of the studies and it eliminates most of the euro effect on trade. change in trade before and after long period – several decades – and then to let the trend explain the of overcoming this inherent difficulty is to estimate the trend over a way One trend. the include may effect euro the or effect euro the

P C P P P P P D P P P P P P anel anel anel anel anel anel anel anel anel anel anel anel ross-section ynamic ynamic panel ethod 9. Berger and Nitsch (2008). 1980s and 1960s and creating the Inner Market in the late 1960s and 1990s. R Within Within euro area

2% % 26–83 0–22 0–22 % 9–13 9–13 % 9–14 9–14 % 3% 0–15 % 0–15 2–6 2–6 % 14% 29% 15% 0% 12–200 12–200 % 28% esults

1970s and the creation of the Inner Mar- 83 ) ( 1999. This approach is used by one and non-euro area and non-euro Between euro Between 0–1 0–1 % 22–24 % [not estimated] 1–9 1–9 % N [not estimated] M [not estimated] 8% [not estimated] 8% [not estimated] [not estimated] 12–14 12–14 % o trade diversion ixed ixed results

1980s and 9 How- 83 TRADE AND INVESTMENT 84 chapter 5 icant from been subjected to euro »treatment« jumps up and is statistically signif- significant deviations respectively. It is quite clear that trade that has Half-toned bars in Figure guage, a common legal system or participation in the Inner Market. lan- common a distance, geographical as such time, over constant rates, tariffs and all factors that are specific to each country pair and been accounted for. These factors include changes in countries and relative to non-euro to euro countries respectively, and trade between non-euro countries, exports from euro to non-euro countries and exports from trated in figure same applies to trade between members and outsiders. This is illus- of other factors are removed suggests the a euro effect does exist. The union jumps up in insignificant effects. insignificant S A 5.3 Figure ource: ource: Flam and

% % euro between trade in difference percentage the show bars The The fact that trade between the original members of the currency 40 30 20 20 35 25 25 –5 –5 10 10 15 15 0 0 5 5 1996 1996 1999 onwards. The pre-treatment period has deliberately N N (2007). ordström 97 97 5.3 To Fr W nnual euro effects on trade. effects euro nnual om euro ithin euro 1999 and remains at a higher level after the effects euro 98 98 ar 1995, when factors other than the euro have ea 99 99 ar 5.3 indicate statistically significant and in- ar ea ea 2000 2000 ote: ote: 84 ) ( H alf-toned bars indicate statistically statistically bars indicate alf-toned 01 01 02 02 03 03 04 04 gdp 05 05 s, exchange Elimination of nominal exchange rates lowers the hurdle. unfavorably. moves subsequently exchange the if recover to hard reason may be that starting to export involves fixed costs which are on foreign direct investment. theoretical argument and shows that exchange rate misalignment has negative the Schiavodevelops years. (2007) recent in currencies major other against dollar effects a duration of more than a year and often several years, such as the movement of the yearly exchange rate changes) and not on low-frequency data, i.e. movements with volatility of exchange rates. and finds that fixing increases trade by (2006) estimates the effects of fixing the exchange rate bilaterally on bilateral trade been kept short – on trade has been unable to find any significant negative effects. tensive empirical research on the impact of exchange rate uncertainty cies is estimated at a fraction of one percent, and considering that that the the bulk cost of of the exchanging,ex- hedging and handling curren- coincide with the euro effects. also that this part of the increase in total exports is slight. search indicates that the euro has in fact given rise to new exports, but rate uncertainty can therefore have a substantial positive effect. exchangenominal of elimination the that and trade, on impact tive that the risk of such long-term movements has a substantial and nega- against long-term movements in nominal exchange rates. We believe can be hedged against at a small cost, but it is not possible to hedge change rates with different national currencies. Short-term variability exchange rate uncertainty by reducing the variability of flexible ex- reducing from different quite is currency, common a with rencies cur- national replacing by irrevocably and completely uncertainty One possibility is that the effect of eliminating nominal exchange rate borders in the euro area can amount to a sizable total cost saving. reductionsin the cost of shipping intermediate inputs across national tion and of using inputs from suppliers in the euro euro area areaexporters more has competitive. fallen. The Smallcost of cross-border produc- to non-euro countries is that by lowering their costs the euro has made 13. 12. 11. 10. It remains to explain how the euro could have such a great impact, Lacking solid evidence, we can only suggest possible explanations. A possible explanation for the substantial effect on exports from euro Baldwin et al. (2008 ) and Flam and Nordström 2007). ( This has been suggested by Baldwin (2006). The empirical research is based on high-frequency data (monthly, quarterly or Shambaugh and Klein by study The (1999). McKenzie by survey the See 1995 to 1998 – to minimize the effect of trends that 35 %. Earlier studies estimated the effect of the 85 ) ( 13

12 Some re- 11 10 One

85 TRADE AND INVESTMENT 86 chapter 5 efit almost as much as producers located in the euro area do. sales, inventories and distribution facilities in one location – they ben- as a platform for exports to the other euro area countries – by keeping euro area. If outside exporters are using one country in the euro area may be explained by the elimination of currency barriers and arrives at a relatively modest effect from joining the currency union. outsiders from joining can be calculated roughly as: other outsiders a boost. partners for other outsider countries and have given their trade with membership would have made the outsiders more attractive as trade its trade with other euro countries more than with outsiders. Second, to the union, since every euro country is estimated as would probably having have increased even increased more had it (or they) belonged euro countries from Denmark (and Sweden and the United Kingdom) gains from joining the currency union. First, exports to the rest of the we cannot draw the conclusion that Denmark would enjoy no trade However, themselves. countries euro the of those than more erage of volatility. level, Sweden an intermediate level and the national currencies and the euro, whereby Denmark shows a very low tude of the variability of the exchange rate between their respective the ranking between the three outsiders is consistent with the magni- pean countries in the control group. It is perhaps no coincidence that increase in exports from outsider to euro countries the is of most due that to also only.Note the countries few Euro- a on depend not do ence-in-differences). responding difference for exports between outsider countries (differ- on average from the average in estimates measure the amount whereby exports in Figure from joining the currency union T he he increase in trade for the outsiders 14. Finally, the increase in exports from outsiders to the euro area euro the to outsiders from exports in increase the Finally, The euro effect on exports (and analogously on imports) for the for imports) on analogously (and exports on effect euro The Denmark’s exports to the euro countries have increased on av- on increased have countries euro the to exports Denmark’s Note that the euro effects are fairly uniform across countries; they In a much cited study for the 5.4 shows estimated euro effects for individual countries. The 14

ecb 1995–1998 and in relation to the cor- 86 ) ( Baldwin (2006) overlooks the second effect uk a relatively high level 1999–2006 differ

within the 4 N . 5 e r u g i F ote: ote: R

ed indicates statistically insignificant effects. insignificant statistically ed indicates % % % –20 –20 –20 40 40 40 60 20 20 20 0 0 0

Denmark Average Austria Average Austria Average

Belgium Belgium Fr Fr Fr om outsiderto om eur UK German German

Sw om eur eden Norway y y Switzerland Spain o to Spain o to

87 ) ( Finland Finland outsiderc eur

Canada eur Fr Fr

anc anc o c

o c e e

Ir Ir ountries elan elan US ountries ountries A d d Japan Netherlands Netherlands Italy Italy Austr Ne w Z alia Portugal Portugal ealand 87 TRADE AND INVESTMENT 88 chapter 5 to produce the extra per cent of imports domestically. In other words, the resources used Assume further that the ratio of exports to imports are assumed to be cost would it add up to a sizable gain. not negligible and the discounted value of all future of the trade gain for increases in trade at the margin. Nonetheless, it is is probably correct in indicating that the gdp per cent. This means that the and that the domestic value added (resource content) of exports is country’s how the economy functions. International trade on does knowledge increase and data more much without precision reasonable recent years instead of the average for time; the trade gains would be greater had we used data for the most The calculation is conservative, since euro effects are increasing over amount. same the by increase will countries, group control the just The calculation also assumes that trade with all outsider countries, not outsiders respectively since the increases are of the same magnitude.) (We do not need to know the shares of trade with euro countries and outsiders likewise increases by as much as the average, that the outsiders’ trade as members of the currency union with other tive to trade with outsiders by as much as the average, The calculation assumes that trade with euro countries increases rela- a goods and services at home. services abroad at less cost than it and goods would other buy take can it to services and produce goods some the exporting By imported the goods and services that it consumes (if that were even possible). gdp Exports to other euro countries It is impossible to translate the trade gains into gains trade the translate to impossible is It To get an idea of the steps necessary to translate the trade gain into Total exports Exports to outsider countries gain of gain, we can consider a hypothetical example. Assume that Assume example. hypothetical a consider can we gain, gdp 0.3 per cent. This example is purely hypothetical, but it per cent more on average to produce the extra the produce to average on more cent per 10 would be much lower if it were forced to produce all 12 per cent of exports to buy

10 per cent more productive than before. 12 per cent trade gain translates into a

88 ) (

= +

12 % times euro area share of 12 % total exports total exports 12 % times outsiders’ share of 1999–2006. gdp gdp gain is only a fraction before joining is 12 per cent more gdp 12 per cent, and gdp gains would 12 per cent. gains with gains

gdp 0.5, 12 50 :a recorded as a portfolio (financial) investment. has – or obtains – more than ten percent of the enterprise concerned. Otherwise, it is on foreign direct investment, rency exchange and nominal exchange rate uncertainty would have It is not immediately clear what effects the elimination of costs for cur- Euro effectson foreigndirect investment to reduce or stop exports fdi affect would uncertainty rate exchange nominal of elimination the which in direction The expect. to us lead might rates exchange ing greater than the empirical research based on the variability of exist- much trade, on effects major have can uncertainty rate exchange plementary to trade. the euro will tend to increase country to serve as a platform for exports to others. If this is so, then euro one in facilities distribution or production establish to outside the euro area. However, it has also made it more attractive for firms should serve to substitute exports for horizontal although the distinction is not always clear. Horizontal cal (when cost differences between different locations are exploited), zontal (when local production is established for local sales), or verti- uncertainty is also an for motive this eliminates currency common A costs and revenues will be more closely matched in terms of currency. certainty in the real exchange rate. By establishing local production, a substitute for trade. Most fdi fdi A large share of the boom in tor or to preempt the acquisition of the foreign firm by a competitor. acquires a foreign firm to gain market power, to eliminate a competi- sitions, and involved little actual transfer of capital across borders. turn of the millennium was in the form of strategic mergers and acqui- 16. 15. We have hypothesized that a complete elimination of nominal of elimination complete a that hypothesized Wehave The euro rendered exports between euro countries less costly, and fdi is not clear. An important function of is more common between old and new , on the other hand, tends to be a complement to trade. Vertical Taylor (2008). A cross-border investment is recorded as foreign direct investment if the investor can also occur for purely strategic reasons. For example, a firm ex ante risk where ex ante fdi fdi fdi fdi within the 89 ) ( that occurred in the euro area at the to the euro area and make in face of an unfavorable exchange . 15

fdi is commonly defined as hori- fdi eu fdi is concerned. It costs less eu -15 is horizontal. Vertical is to hedge against un- members. fdi fdi . Exchange rate Exchange . for firms inside fdi tends to be fdi com- 16

89 TRADE AND INVESTMENT 90 chapter 5 uncertainty should stimulate the of Elimination production. local down close to does it than rate by It is estimated that the euro increased horizontal data is much more reliable than the official kind as regards total stitutes for each other. Thus the direction in which the euro affects on of the studies has used data on authors of the study interpret the powerful effect of the euro as a muchbecame subsequently this but weaker.countries, income The result trated around outside to euro countries by by euro effects on the regarding date to studies few relatively clear.the not of Mostis tive impact on control adequately for the effects of the latter. to failing by Market, Inner the of effects with euro the of effects ing ings. It is possible that the studies that find positive effects are confus- report no such impact. Table T Table 5.2 18. 17. C de de Brouwer, J., A Flam, Flam, S Foad, P 70 per cent. There was an estimated increase in vertical 200 per cent, and horizontal m&a chiavo, chiavo, etroulas, etroulas, It is evident that Much oeurdacier, oeurdacier, uthor(s) S Coeurdacier, De Santis and Aviat (2009). Flam and Nordström (2008). ousa, J. ousa, and J. Lochard (2006) H H both within the euro area and on countries outside it. . and . (2006) S fdi . (2007) P . (2007) R H N . is in the form of mergers and acquisitions (m&a . P 2000, when there was a general surge in ., ., N fdi fdi aap aap and J.- he euro effects on F effects he euro R ordström ordström (2008) . D within the euro area, while the rest of the studies conclude that the euro has had a substantial posi-

e fdi S antis antis and and trade can both be complements and sub- M . Viaene . (2007) Viaene fdi 140 per cent. The effects were concen- 5.2 provides an overview of these find- A m&a . 90 ) ( A m&a DI . viat viat (2009) : O to estimate the effect of the euro verview of research results. results. of research verview from outside to euro countries 17

m&a in the euro area P 1990–2004 1990–2004 1985–2004 1982–2004 1992–2001 1995–2006 1980–2001 1986–2002 m&a eriod

m&a in high- 18 ). One Such from fdi

fdi .

P P M P P P P D anel anel anel anel anel anel ynamic ynamic panel ethod 19 19 % 200 200 % Within euro area R 26 26 % 16 16 % 0 % 300 300 % p [not estimated] esults 4 % 70 % area and non-euro euro Between [not estimated] 8–11 8–11 % [not estimated] 200 200 % ositive ositive on F DI from US T Table 5.2 C de de Brouwer, Brouwer, J., A Flam, Flam, S Foad, Foad, P chiavo, chiavo, etroulas, etroulas, oeurdacier, oeurdacier, uthor(s) S ousa, J. ousa, and J. Lochard (2006) H H . and . (2006) S . (2007) P . (2007) R H N . . P ., ., N aap aap and J.- he euro effects on F effects he euro R ordström ordström (2008) . D

e S antis antis and M . Viaene . (2007) Viaene A . A DI viat viat (2009) : O verview of research results. results. of research verview P 1990–2004 1990–2004 1985–2004 1982–2004 1980–2001 1992–2001 1995–2006 1986–2002 eriod

zontal hori- on effects euro biggest the that note to interesting is It values. union, which acted as a trigger in a period of rapid increases currency in the with equity associated uncertainty rate exchange nominal of Inner Market and, second, the financial integration and elimination the with associated liberalization market product and trade first, of, cent higher. that trade between the euro area and outside countries is about per cent higher on average after stantial. Our own calculation indicates that trade in the euro area is to other long-term factors but the euro effect is probably still very sub- increases over time. Some part of the measured impact could be due currency union and trade between members and outsiders. The effect nomically substantial effects, both on trade between members of the eco- find trade on euro the of impact the estimate Mostthat studies S and trade expected, be might what to contrary the biggest effects of the euro on trade. In other words it seems that, fects of the same magnitude as for trade, but the findings can be ques - other. Several of the studies of the euro’s impact on Trade and complemented one another. P P M P P P P D anel anel anel anel anel anel ynamic ynamic panel ethod ummary ummary It is not clear what effect we should expect on m&a fdi were registered in the manufacturing sectors exhibiting

can be substitutes as well as complements for one an- 19 19 % 200 200 % Within Within euro area R 26 26 % 300 300 % 16 % 0 % p [not estimated] esults 1999 than in the preceding years, and 91 ) ( 4 % 70 % and non-euro area and non-euro euro Between [not estimated] 200 200 % 8–11 % [not estimated] ositive ositive on F fdi fdi to some extent some to fdi DI from from the euro. indicate ef- US 12 per 24 91 TRADE AND INVESTMENT 92 chapter 5 sifying the work of completing the Inner Market. boost the positive effects of the euro on trade by continuing and Hence,reinforcing. mutually can words states other member in are inten- currency is important for the functioning of the Inner Market. They condition for the trade-creating effect of the euro, while the common transport services. The Inner Market is likely to remain an important cial services, telecommunications, postal services, energy supply and finan- as such sectors, service many in remain barriers particular), in (defense domestic largely still is procurement public costs, tive administra- substantial cause rates tax different recognition, mutual For instance, there are inadequate product standards and insufficient incorrect. sometimes is application their and legislation national in and people. Some Inner Market directives still remain to be included ket genuinely becomes a common market for goods, services, capital joined the currency union. Third, much is left before the Inner Mar- only ond, and households to take full advantage of the common currency. Sec - common currency has not been exhausted. First, it takes time for firms did have an important impact on investment decisions. currency, single a of introduction the followed that uncertainty rate exchange nominal of elimination and integration financial the that manufacturing, both within the euro area and from it. This indicates There were, however, very strong euro effects on horizontal the euro have not been correctly separated in the statistical analysis. tioned. It seems that the effects of the Inner Market and the effects of Baldwin, Richard, Frauke SkudelnyandDariaTaglioni (2006 ), »Trade Baldwin, Richard andPaul Krugman(1989 ), »Persistent Trade Effectsof Anderson, JamesandEricvanWincoop (2003),»GravitywithGravitas: R eferenc 446, EuropeanCentral Bank. effects oftheeuro–evidence fromsectoraldata«,Working Paper Series 635–654. Large Exchange RateShocks«, QuarterlyJournalofEconomics , 419pp. 170–192. A Solution totheBorderPuzzle«, American EconomicReview , 93pp. The potential for stimulating trade and investment through the through investment and trade stimulating for potential The of the of 16 e s member states in the European Union have Union European the in states member 27 92 ) ( m&a in Faruqee, Hamid(2004),»Measuring theTrade Effectsofemu de Sousa, José andJulieLochard (2006),»Does theSingleCurrency De Nardis, Sergio andClaudioVicarelli (2003),»TheImpactofEuroon Coeurdacier, Nicolas,Roberto De SantisandAntoninAviat (2009), Chintrakarn, Pandej (2008),»EstimatingtheEuroEffectsonTrade with Bun, MauriceandFranc Klaassen(2007),»TheEuroEffectonTrade is Brouwer, Jelle, Richard Paap andJean-Marie Viaene (2008),»TheTrade Berger, Helge andVolker Nitsch (2008),»Zooming Out:TheTrade Effect Barr, David,Francis BreedonandDavidMiles(2003),»LifeontheOut- Baldwin, Richard, Virginia DiNino,LionelForntagné, Roberto A.De Klein, Michael and Jay Shambaugh(2006),»FixedExchange Rates and Gomes, Tamara etal.(2006),»TheEuroandTrade: IsthereaPositive Frankel, Jeffrey (2008),»TheEstimatedEffectsoftheEuroonTrade: fdi Foad, Hisham(2006),»Export-Oriented Flam, HarryandHåkanNordström (2008),»TheEuroImpacton fdi Flam, HarryandHåkanNordström (2007),»ExplainingLargeEuro Flam, HarryandHåkanNordström (2003),»Trade Volume Effectsofthe Affect fdi Trade: The(Early)EffectisnotsoLarge«,unpublishedmanuscript. Economic Policy, Vol. 57. »Cross-Border Mergers andAcquisitions andEuropeanIntegration«, 186–198. Propensity Score Matching«, ReviewofInternationalEconomics,16pp. Statistics, 69pp.473–496. not asLargeCommonly Thought«,OxfordBulletinofEconomicsand Finance, 27pp.188–208. and fdi Finance (forthcoming). of theEuroinHistoricalPerpective«, JournalofInternationalMoneyand side«, EconomicPolicy, 18pp.573–613. Papers No. 321. on Trade andForeign DirectInvestment«,European EconomyEconomic Santis andDariaTaglioni (2008),»StudyontheImpactofEuro Trade«, JournalofInternationalEconomics , 70359–383. Effect?«, unpublishedmanuscript. Unions AmongSmallerCountries?«, unpublished manuscript. Why areTheyBelow HistoricalEvidence onEffectsofMonetary Euro«, unpublishedmanuscript. Revisited andRevised«, unpublishedmanuscript. unpublished manuscript. Effects onTrade: TheExtensiveMarginandVertical Specialization«, Euro: AggregateandSector Estimates«,unpublishedmanuscript. Working Paper 154. Effectsofeu ? AGravity-LikeApproach«, unpublishedmanuscript. Enlargement«,JournalofInternationalMoneyand 93 ) ( andtheAdoption ofthe «, imf

93 TRADE AND INVESTMENT 94 chapter 5 Taylor, Christopher(2008),»Foreign DirectInvestmentandtheeuro: Schiavo, Stefano(2007),»Common Currenciesandfdi Petroulas, Pavlos (2007),»TheEffectoftheEuroonForeign Direct Micco, Alejandro,ErnestoSteinandGuillermoOrdoñez,»TheCurrency McKenzie, Michael (1999),»TheImpactofExchange RateVolatility on The FirstFiveYears«, CambridgeJournalofEconomics,32pp.1–28. Economic Papers, 59pp.536–560. Investment«, European EconomicReview,51pp.1 37, pp.317–356. Union EffectonTrade: EarlyEvidence fromemu International tradeflows«,JournalofEconomicSurveys,13pp.71–106. 94 ) ( 468–1 «, EconomicPolicy, Flows«,Oxford 491. chapter 6

T H E T H r e e ou t s i d e r s a n d T H E m o n e ta ry u n i o n

efore the start of monetary union in 1999, Den- mark, Sweden and the uk decided that they did not want to participate. Denmark and the uk obtained opt-out clauses in the Maastricht Treaty, while Sweden has chosen to stay out unilaterally. In all three countries, the key reason for this decision was – and still is – a negative view among the electorate. The Danish and Swedish governments have been in favor of membership and have put the issue before the people in a referendum (in Denmark twice). In the uk, the government has been in favor in principle, but with caveats. This chapter reviews the costs and benefits of being outside the monetary union for Denmark, Sweden and the uk in view of the evidence from the last ten years. Building on the discussion in the preceding chapters, we consider the effects in relation to monetary policy,

( 95 ) 96 chapter 6 sentially »appealed to the purse of the Danes«. sised that the efficiency arguments in favor of adopting the euro, es- empha- Government the referendum, the to Prior conducted. was of opt-out clauses, including exemption for transition to the third stage 1992, it was rejected by a slight majority. Denmark then Treaty.obtained four However, when the Treaty was presented in a referendum in not be in the national economic interest.« not at the present time been made and a decision to join now would that »a clear and unambiguous case for was assessment the Treasury’s Thus, tests. flexibility and vergence the investment and financial services tests were met, but not the con- members of the monetary union. majority of political reasons – to retain sovereignty – the Danes voted No with a should be put to a referendum of the British people. on growth and stability. Furthermore, a decision by the government uk flexibility in case of problems, (3) conditions for investments into the terms of (1) business cycle compatibility (convergence), (2) sufficient in tests economic five stated government The consent. popular be interest, the case should be clear and unambiguous, and there should number of important caveats. Membership should be in the national mitted itself to the principle of joining the single currency, but with a wanted to join the monetary union. In granted an opt-out clause, leaving it up to the In the negotiations leading up to the MaastrichtTreaty,the to up leading negotiations the In the S background for why Denmark, Sweden and the the reviewing by however, Westart, outsiders. three the for cance signifi- any had has union monetary the into states member new of have experienced reduced influence in the outsiders the whether – issues We political kets. discuss briefly also fiscal policy, labor markets, trade and investment, and financial mar- hort hort background 1. emu , (4) competitiveness of the financial industry, and (5) overall effect n otat te aih oenet cetd h Maastricht the accepted Government Danish the contrast, In In Marcussen (2005). 2003, an extensive review by the , the monetary union. In September 53 percent. 96 ) ( 1997, the uk uk eu membership of Treasury concluded that 2000, a new referendum uk and whether the entry 1 However, largely for uk uk to decide whether it government com- are not currently emu uk was has therefore – conveniently – not put to the test. is union monetary the joining Sweden of issue The rate. exchange ed that Sweden should wait. than the arguments in favor. The commission therefore recommend- stronger were membership against arguments the time, that at that, most and the most negative of all and the British. In the October eu detrimental for democracy. would have negative consequences for Sweden’s sovereignty and be membership union monetary full that argued sceptics the of Many of majority a and held was union monetary Exchange Rate Mechanism (erm changes to its central bank legislation and does not participate in the not qualify at present, since the country has not made the necessary does Sweden membership. Swedish on decision final the take will parliament Swedish the that maintained nevertheless has ernment the euro whenever it satisfies the entry conditions. The Swedish gov- 41 percent says Yes and in the the among positive most third being a member of the European Union«. This makes Denmark the would you say that your country has on balance benefited or not from Danes say Yes to the question: »Taking everything into consideration, In terms of euro area is comparable to the unweighted average of the outsiders. the of rate growth average unweighted The countries. bigger the in eu mark. However, the uk Growth in real well. done have outsiders three the level, economic overall the At Mac 3. 2. . The Danes are generally much more positive than the Swedes the than positive more much generally are Danes The . average. Employment growth has been higher in the euro area euro the in higher been has growth Employment average. than in the euro area, while it has been somewhat lower in Den- In The three outsiders differ with respect to their overall view on the In September adopt TreatyMaastrichtto the required to according is Sweden Lindahl and Naurin (2005). Calmfors et al. (1996 ). r 1996, a Swedish government commission of experts concluded oe conomi gdp gdp per capita, all the three outsiders are well above the 2003, a referendum on Swedish membership in the has been considerably higher in Sweden and the eu c average is pushed down by the weak situation perf 3 2 uk eu 97 ) ( 2006 Eurobarometer, orm eu

ii 39 percent, making them the third members. In contrast, in Swedenin contrast, In members. ) to meet the condition of a stable members respectively. anc e percent voted No. voted percent 56 74 percent of 97 THE THREE OUTSIDERS AND THE MONETARY UNION 98 chapter 6 etary union membership. the economy that could or would be particularly influenced by mon- monetary union or is it caused by other factors? Let us look at parts of this performance? Does it depend on the freedom of being outside more the successful of the monetary union countries. But what lies behind large and growing deficit. ance of the euro countries, while the had a positive fiscal balance on average compared to the negative bal- fiscal policy, two of the three outsiders, Denmark and Sweden, have weighted average over the euro countries is been low in many of the monetary union countries also, and the un- However, the average annual inflation deviation from cent, with the average annual deviation in the range fiscal policy. Inflation has been kept fairly close to the target of the euro average. than outsiders three all for lower markedly still was unemployment ployment being much higher in the euro area at the outset. In than among the outsiders, but this must be seen in light of the unem- 3. 3. 4. 4. 2. 2.

1. 1. the outsiders. and – area the euro performance Macroeconomic Table 6.1 a P

A R

Fiscal Fiscal balance E T R Gross public debt public Gross I

U I % rate of labor. nflation nflation nflationdeviation rade balance er capita; er capita; mployment growth mployment Overall, the performance of the outsiders is comparable to the to comparable is outsiders the of performance the Overall, and monetary of area the in well done also have outsiders The eal eal G eal G eal bsolute value from of bsolute 2 deviation annual percent. nnual rate; nnual per capita nemployment DP growth DP

2 OE

C D = 100 in 2000. 5 5

5 4

PPP ; OE

C D = 100 in 2000. 2.0 94.3 80.2 2.3 –4.3 9.6 1.0 P

1989–98 0.1 3.7 uro Euro area eriod eriod averages 98 ) (

uk 6 D 1999–07 0.6 109.9 71.8 2.2 –1.8 8.3 1.6

1.0 2.1 in recent years has run a fairly

0.8 percent. In terms of

1989–98

d 0.7 109.8 69.7 2.2 –1.9 7.1 4.7

0.0 2.5 0.4–8 percent. S enmark 2 percent has

1999–07

0.4 128.1 31.8 2.0 2.4 4.6 4.6

0.3 2.1 2008, 2 per-

6. 6. S

1989–98 5. 5.

s 3.0 102.3 82.5 1.5 –3.4 5.8 3.6

–1.2 4.1 ource: http://stats.oecd.org, ource: http://stats.oecd.org, U weden

by 12 weighted countries population. % of G DP

1999–07 0.8 132.2 46.9 3.2 1.4 4.9 6.5

0.4 1.4

E conomic conomic 1989–98 u 1.8 96.8 53.4 2.1 –3.7 8.3 –1.1

–0.1 3.7 K

utlook utlook 1999–07 0.6 119.7 47.5 2.7 –1.3 5.2 –2.2

0.2 1.6 N o. o. 83,

OE C Factbook D 2008. Factbook 1989–98

unweighted 2.4 100.7 73.3 2.9 –4.0 8.2 1.7 uro Euro area 0.4 4.0

1999–07 0.8 126.6 56.8 3.0 –0.8 6.9 2.9 0.8 2.4 3. 3. 4. 4. 2. 2.

Macroeconomic performance – the euro area and the outsiders. and – area the euro performance Macroeconomic Table 6.1 1. 1. a P

A R

E Fiscal Fiscal balance T R Gross public debt public Gross I

U I % rate of labor. nflation nflation nflationdeviation rade balance er capita; er capita; mployment growth mployment eal eal G eal G eal bsolute value from of bsolute 2 deviation annual percent. nnual rate; nnual per capita nemployment DP growth DP

2 OE

C D = 100 in 2000. 5 5

5 4

PPP ; OE

C D = 100 in 2000. 94.3 2.0 80.2 2.3 –4.3 9.6 1.0 P 1989–98 0.1 3.7 uro Euro area eriod eriod averages

6 D 1999–07 109.9 0.6 71.8 2.2 –1.8 8.3 1.6

1.0 2.1

1989–98

d 109.8 0.7 69.7 2.2 –1.9 7.1 4.7

0.0 2.5 S enmark

1999–07

128.1 0.4 31.8 2.0 2.4 4.6 4.6

0.3 2.1

ber positive in a boom when the size of the euro area, a single country Council, taking the effects for the whole euro area into account. policy.Given The monetary policy interest rate is set by the has maintained a fixed exchange rate towards the euro. While Sweden and the The three outsiders have chosen different monetary policy regimes. Monetary policy when it comes to to the euro average. How do the outsiders stand on this count? country to the extent that the cyclical situation in the country is close rate. Thus, the euro interest rate will only suit an individual member reduce the importance of the issue. Furthermore, there is also a ten- in the stronger in Sweden than in the euro area. However, the fluctuations For example, the downturn in the early 6. 6. S

1989–98 5. 5.

s 102.3 3.0 82.5 1.5 –3.4 5.8 3.6

–1.2 4.1 ource: http://stats.oecd.org, ource: http://stats.oecd.org, U weden

4. by 12 weighted countries population. % of G Members of the monetary union have no independent monetary Figure – The will by itself have a small or negligible impact on the interest the on impact negligible or small a have itself by will gdp DP

gdp .

6.1a shows that there have been fairly large discrepancies 1999–07 132.2 0.8 46.9 3.2 1.4 4.9 6.5

0.4 1.4 -gap seem to have become smaller over time, which would -gap is the difference between actual and the trend of gdp

gdp -gaps between the outsiders and the euro area. E uk conomic conomic 1989–98 u 96.8 1.8 53.4 2.1 –3.7 8.3 –1.1

–0.1 3.7 is above trend and negative in a downturn. K

have adopted an inflation target, Denmark O

99 ) ( utlook utlook 1999–07 119.7 0.6 47.5 2.7 –1.3 5.2 –2.2

0.2 1.6 N o. o. 83, 1990s was much sharper and – even the

OE C Factbook D 2008. Factbook 1989–98

unweighted 100.7 2.4 73.3 2.9 –4.0 8.2 1.7 uro Euro area 0.4 4.0 uk ecb if it was a mem-

gdp

Governing 1999–07 126.6 0.8 56.8 3.0 –0.8 6.9 2.9 0.8 2.4 , normally 4

99 THE THREE OUTSIDERS AND THE MONETARY UNION 100 chapter 6 T 6.1 Figure and for each of the three outsiders. outsiders. of the three for each and

–1 % % 20 –4 –6 –8 –5 –2 10 15 0 0 0 4 5 2 1990 Q1 6.1b 6.1a 199 Q1 int Short-t 2 eur GDP-gap er 199 Q3 est o ar 1994 2 Q1 erm domestic ra ea he upper left panel displays the G displays panel left he upper te Sw GDP-gap 199 eden 1996 Q1 GDP-gap Q1 5 Short-t 1998 Q1 199 Q3 DENMARK erm eur 7 T 100 ) ( he other three panels show the G show panels three he other 2000 Q1 2000 o int Q1 200 er Q1 est UK GDP-gap 2 200 Q3 ra DP te 2004 2 -gap for the euro area area for the euro -gap Q1 2005 Q1 2006 Q1 Denmark GDP-gap 200 DP 2008 Q3 Q1 -gap -gap 7

% –1 % 20 –5 –5 10 10 15 15 0 0 0 5 5 1990 1990 Q1 Q1 1992 1992 Q1 Q1 int Short-t Short-t inte er est inte domestic Short-t 1994 1994 re erm domestic Q1 Q1 st ra re erm euro te ra st te erm ra 1996 1996 euro Short-t GDP-gap te Q1 Q1

inte erm GDP-gap 1998 1998 S Q1 Q1 re WEDEN st UK ra te 2000 2000 Q1 Q1 2002 2002 Q1 Q1 2004 2004 Q1 Q1 2006 2006 Q1 Q1 2008 2008 Q1 Q1 –1 % % 20 –4 –6 –8 –5 –2 10 15 0 0 0 4 5 2 1990 Q1 199 Q1 int Short-t 2 eur GDP-gap er 199 Q3 est o ar 1994 2 Q1 erm domestic ra ea te Sw GDP-gap 199 eden 1996 Q1 GDP-gap Q1 5 Short-t 1998 Q1 199 Q3 DENMARK erm eur 7 2000 Q1 2000 o int Q1 200 er Q1 est UK GDP-gap 2 200 Q3 ra te 2004 2 Q1 2005 Q1 2006 Q1 Denmark GDP-gap 200 2008 Q3 Q1 7 euro interest rate. interest euro to the short-term as compared rate in the country, interest the short-term and

% –1 % 20 –5 –5 10 10 15 15 0 0 0 5 5 1990 1990 Q1 Q1 6.1d 6.1c 1992 1992 Q1 Q1 int Short-t inte Short-t er est inte domestic Short-t 1994 1994 re erm domestic Q1 Q1 st ra re erm euro te ra st te erm ra 1996 1996 euro Short-t GDP-gap te Q1 Q1

inte erm GDP-gap 1998 1998 S Q1 Q1 101 ) ( re WEDEN st UK ra te 2000 2000 Q1 Q1 2002 2002 Q1 Q1 2004 2004 Q1 Q1 2006 2006 Q1 Q1 2008 2008 Q1 Q1 101 THE THREE OUTSIDERS AND THE MONETARY UNION 102 chapter 6 the individual members of the monetary union. monetary the of members individual the sistent with an analysis of how well the difference in interest rates, as can be seen in Figure to the euro area has been smaller, which is also reflected in the small fall in property prices sharper. recent the making presumably further, prices property in surge the otherwise in one respect. A lower interest rate would have stimulated been too high, the subsequent evolution of the than in the euro area might have been more appropriate. 2006–2007 est rate parallels that of the euro, as Figure a fixed exchange rate with the euro, implying that the Danish inter- has lost little in terms of monetary stabilization policy from keeping suited Denmark even better than Sweden. This suggests that Denmark erlands, than for the less suitable for two monetary union members, Ireland and the Neth- the that the euro interest rate would fit well for Sweden and less well for was below its target, suggesting that the that suggesting target, its below was British economy further. While the monetary union, the low euro interest rate would have stimulated the the euro interest rate at the time. If the was which rate interest an set England of Bank downturn. As can be seen from Figure creasing inflation albeit from a low level, while the euro area was in a ences. Notably,ences. in rule, with the same weights for all countries. for each country based on a stylized monetary policy rule, a forward-looking Taylor now than it was in the years, the the study by the European Commission of monetary union after ten dency towards more synchronization of business cycles. According to euro area since the mid-1990s. that Swedish business cycles have become more correlated with the 7. 6. 5. For Sweden, the difference in the cyclical position as compared as position cyclical the in difference ForSweden,the By contrast, the same analysis finds that the euro interest rate has In spite of more synchronization, there are still sizeable differ- sizeable still are there synchronization, more of spite In uk. However, it also finds that the euro interest rate has been even Calmfors et al. (2007). Specifically, the study calculates the optimal interestSöderström rate (2008). European Commission (2008). uk gdp economy is much more synchronized with the euro area -growth was relatively high and a higher interest rate the 2004 uk. 1990s. uk 5 Correspondingly, another study finds 6 102 ) ( economy was above trend, with in- with trend, above was economy uk inflation rate for several years uk ecb 6.1d, the upshot was that the uk had been a member of the interest rate policy has fit 6.1b shows. However, in interest rate may have may rate interest uk 7 percent above percent 2–3 The analysis finds analysis The economy suggests 6.1c. This is con- 0. depreciated even further. has depreciated back to around the original level, and the pound has Wethe of evolution smoother a to led have would this that observe the euro exchange rate and on the trading patterns of the countries. the series in Figure linked to the euro, formed by multiplying the series in Figure fective exchange rate in the hypothetical case that the currencies were sizeable fluctuations have persisted. Figure krona in the early period, and more stability later on. For the pound, rate for the outsiders. We notice considerable volatility for the Swedish extent following the strong pound and the Swedish krona appreciated against the euro, to some In the first years after the introduction of the euro in the outsiders have fared on this account if they had adopted the euro? N E 6.2 Figure 1. 0. 1. ote: ote: 05 95 15 1. 9 1 1 Figure Another side of monetary policy is the exchange rate. How would L ower value indicates stronger currency. stronger ower value indicates January DKK/ 2000 6.3a shows the nominal effective (trade-weighted) eur o xchange rates against the euro. against rates xchange SEK/ 6.2 This implies neglecting any possible effect on January 200 euro 2 us dollar (Figure 103 ) ( January 2004 6.3b shows the nominal ef- 6.2). However, the krona January 2006 1999, the British GBP / eur January exchange o 2008 6.3a by 103 THE THREE OUTSIDERS AND THE MONETARY UNION 0. 0 1. 0. 1. .85 05 95 15 1. 9 1 1 January 2000 DKK GBP January 200 2 January 2004 January SEK 2006 January 2008 104 chapter 6 values indicates stronger currency. stronger indicates values rates). exchange of bilateral averages geometric weights, based trade time-varying Upper panel: the effective exchange rate(B exchange the effective panel: Upper 6.3 Figure 0. 0 0. 0 1. 1. 0. 1. 0. .85 .85 05 95 05 95 15 1. 1. 9 9 1 1 1 1 6.3b 6.3a L N rate to ifeuro. linked the exchange effective ower panel: January January DKK 2000 2000 DKK GBP January January GBP 200 200 2 2 104 ) ( January January 2004 2004 January January SEK 2006 2006 SEK IS , broad index, index, , broad ote: ote: January January 2008 2008 H igher igher 0. 0 1. 0. .85 05 95 1. 9 1 1 January DKK 2000 January GBP 200 2 January 2004 January 2006 SEK January 2008 competitiveness for a country that is member of a monetary union. are rigid downwards in nominal terms, it may be difficult to restore competitiveness relative to other euro area countries. international in loss considerable a to leading growth, productivity to compared as growth price and wage high persistent experienced tique of monetary union). Greece, Ireland, Portugal and Spain have and fuel inflation further (this is often referred to as the Walters’ Cri- interest rates in the country, which in turn will stimulate the economy real reduce will inflation higher whole, a as area euro the in mined deter- interest nominal the with that is reason One persistent. very monetary union is that excessive inflation in a given country may be European the of experience The competitiveness. exchangeor rate rates. as such fundamentals, economic the from nected discon- are that reasons for occur rate exchange the in fluctuations exchange rate? The bulk of empirical research suggests that short-run to more persistent changes. to fewer short run fluctuations in the effective exchange rate, but also this period, it seems that monetary union membership would have depreciation led of the euro and the subsequent appreciation. Thus, over nominal effective exchange rate, to a large extent following the early the economy by introducing additional volatility. in other sectors, but they have also to some extent acted to destabilize movements have helped to stabilize the economy after disturbances model of the Swedish economy finds that, since of a Swedish membership in the monetary union within an estimated in some cases have a stabilizing effect. A study of the consequences are costly to the economy. However, exchange rate fluctuations may outside the monetary union. All the outsiders had a fairly recent his- policy monetary of credibility the maintain to was outsiders the for avoiding a loss of competitiveness. thus and appearing, from inflation excessive prevent extent greater a to can policy monetary independent with country a contrast, By 11. 10. 9. 8. Another issue is the risk of more persistent imbalances in the real What would have been the effect of a smoother evolution of the of evolution smoother a of effect the been have would What In the debate about monetary union membership, one concern one membership, union monetary about debate the In Söderström (2008). See for example the recent survey by Rigobon (2008). 8 See evidence in Dickens et al. (2007) and Holden and Wulfsberg (2008). European Commission (2008), This means that nominal exchange rate fluctuations in general 105 ) ( 58–60. 1993, exchange rate 9 gdp 10 When wages and interest and 11

105 THE THREE OUTSIDERS AND THE MONETARY UNION 106 chapter 6 argument for entering the monetary union. strong a be would it independence, increased given were Riksbank deed, the Swedish monetary union commission argued that unless the a way of reducing the risk of repeating this history to a minimum. In- tory of high inflation, and monetary union membership was seen as fairly big deficit in recent years – close to theThe debt. public muchreduced a Stability and Growth Pact tainability, with a sizeable fiscal surplus on average and consequently done considerably better than the euro countries in terms of fiscal sus- fiscal policy to stabilize the economy. than it does for outsiders. Second, an increased burden is placed on binding ceiling on the budget deficit and the public debt for members tions for fiscal policy. First, the Stability and Growth Pact sets a more implica- main two have would union monetary the Membershipin Fiscal policy the at the euro area. Third, Denmark has an intervention agreement with a fixed exchange rate, as almost half of Denmark’s exportsbeen are small. directed It has also reflected the substantial gain from maintaining Danisheconomyadoptinginterestgenerallyfromeurohastherate high correlation of the business cycles, implying that the strain for the credibility of the Danish fixed exchange rate regime has reflected the remained perfectly credible, until the recent financial crisis. The high to do so in the maintain a fixed exchange rate, and many European countries failed to difficult increasingly been has it capital, mobile internationally sive for the Danish fixed exchange rate regime. In a world of highly credibility for their respective monetary regimes. reform was carried through, and all the three countries have achieved ferential, however, has increased to over one percent. stability in the sary to maintain the parity, conditional on not being a threat to price 13. 12. Table By some accounts, maintaining credibility has been most impres- ecb See http://europa.eu/scadplus/leg/en/lvb/l25082.htm Calmfors et al. (1997 ). , allowing for unlimited intervention by the 6.1 suggests that in recent years Denmark and Sweden have ecb 1990s. Denmark’s fixed exchange rate, however, has . 13 In the current financial crisis the interest rate dif- 106 ) ( uk , on the other hand, has run a run has hand, other the on , 12 However, the Riksbank ecb if such is neces- among the euro countries. limit of discretionary fiscal policy in the countercyclical consistent no been has there However, stabilizers. cluding the three outsiders, have fairly large and effective automatic Chapter in evidence the union, policy in stabilization as a result of being a member of the monetary 1990s and have pursued a sound fiscal policy since. to have learned from their experience of high public debt in the early ibility of monetary policy. Furthermore, Denmark and Sweden seem in part because bad fiscal discipline may easily undermine the cred- sustainable fiscal policy is as important outside the monetary union, an active stabilisation policy in a downturn. However, maintaining a fiscal surplus in a normal cyclical situation so as to be able to conduct Stability and Growth Pact, and they also have an incentive to obtain a bers are rather similar. Monetary union members are restricted by the ance may reflect that the incentives facing members and non-mem- to meet the entry conditions before eral countries to improve their fiscal balances as they were struggling difference as regards fiscal discipline since big a made has itself in membership union monetary that conclude and being able to reduce public debt substantially. Thus, one cannot bers have also done well in this context by maintaining a fiscal surplus union membership. For the this account Denmark and Sweden would be well suited for monetary policy.fiscal sound a maintain to willingness on political Thus, sive independent evaluation of Swedish fiscal policy – indicates an providing of task the an with agency government a impres- – council fiscal to stabilize the economy.the stabilize to exchange rate vis-à-vis the euro requires that the fiscal policy is used Denmark, politicians have been well aware that maintaining a fixed economy, even under the rules of the Stability and Growth Pact. In it possible for them to use fiscal policy to stabilize fluctuations in the contrast to the clear countercyclical fiscal policy in the 14. However, as pointed out in Chapter Turning from fiscal sustainability to the increased role for fiscal for role increased the to sustainability Turningfiscal from The slight effect of monetary union membership on the fiscal bal- The sound fiscal position of of position fiscal sound The and Denmark make should Sweden See Andersen and Chiriaeva (2007). 3 percent – but has a public debt that is lower than the average 14 In Sweden, the recent introduction of a of introduction recent the Sweden, In uk 107 ) ( , the current large fiscal deficit would eu shows that most that shows 3 countries over the last decade, in 1999. 3, some of the euro area mem- 1999, but it did force sev- eu us countries, in- countries, . 107 THE THREE OUTSIDERS AND THE MONETARY UNION 108 chapter 6 etary union members. reforms to increase labor market flexibility than the bulk of the mon- market labor extensive more undertaken also have they years, ten ment rates than most of the monetary union members. Over the last unemploy- lower and employment higher having union, monetary ployment. The outsiders seem well prepared for membership in the fluctuations lead to volatile employment levels and persistent unem- raises the demand for labor market flexibility to avoid having cyclical union monetary a within policy monetary lackindependent The of Labor market and wage setting rate caused by excessive wage growth, as pointed out earlier. is less potent as a measure to restore imbalances in the real exchange may run contrary to the demands of stabilization. Hence, fiscal policy Fiscal policy is also often influenced by political considerations that purchases may have adverse effects on the efficiency of the economy. in a timely fashion and that frequent changes in tax rates and public tions, including that it takes more time to implement, is limita- harder known to use well are There policy. monetary independent an of omy, one should remember that it cannot fully substitute for the lack rules of the Stability and Growth Pact. suggest that more time would be needed to be prepared for the fiscal flexibility in the that is achieved in the the monetary union. It was argued that »the less progress on sion flexibility was scepticism as to whether flexibility would be sufficient within uk studies mentioned above concluded that »we cannot be confident that Europe, the in some monetary union countries in the mid-1990s. monetary union, which partly reflects the very low employment rate membership was secured. carried out more reforms before becoming members and less when 15. flexibility, while improved, is sufficient.« Underlying this conclu- Even if fiscal policy can and should be used to stabilize the econ- A key aspect of the labor market is wage setting. As pointed out in In spite of the the in higher been has hand, other the on growth, Employment See European Commission (2008), 2003 Treasury Assessment based on the monetary union uk uk economy«. labor market being among the most flexible in 15 eu In contrast, many monetary union members , the greater the premium on a high level of 108 ) ( 80–82. introduction of the euro, but also in Swedenthe in and also but euro, the of introduction restraint has increased not only in many euro area countries after the in countries with centralized wage setting . recent research, a strict inflation target may induce wage moderation tives to coordinate on wage restraint. flation target may discipline wage setters, it also weakens their incen- this effect would not be relevant for them.) decentralized wage setting and Denmark has a fixed exchange rate, so cipline imposed by the Riksbank on the power of unions. (The increase equilibrium unemployment in Sweden by reducing the dis- would union monetary the in membership that suggests argument duces the value of this finding. whichtightness, re- market labor and variables suchinstitutional as setting, wage affect to likely also are that variables other of host for straint and monetary regime. However, this analysis does not control re- wage between relationship any for support no find they words, wage setting and the common interest rate in the euro area. euro the in rate interest common the and setting wage national between link clear a be longer no would there since target inflation national a and setting wage centralized with country a for moderation wage such remove may union monetary the into entry of unemployment. moderation and consequently a permanently lower equilibrium level amplify the adverse effect on employment. This should induce wage growth will be met by a sharp rise in interest rates, which in turn will centrally agreed wage solutions«. claim that monetary union membership has »reinforced demands for ing to lower equilibrium unemployment. Indeed, Finnish observers lead- coordination imply may Denmark, in as rate exchange fixed for coordinated wage restraint within the monetary union, or with a 20. 19. 18. 17. 16. However, one can also argue that precisely because a national in- Building on this effect, some researchers have pointed out that out pointed have researchers some effect, this on Building Posen and Popov Gould (2006). Tiilikainen (2005). Holden (2005). Soskice and Iversen (1998) and Cukierman and Lippi (2001). Bratsiotis and Martin (1999) and Soskice and Iversen (2000). 109 ) ( 19 Other researchers find that wage 18 Thus, the stronger incentives 16 The idea is that high wage uk. 20 In other In uk 17 This has 109 THE THREE OUTSIDERS AND THE MONETARY UNION 110 chapter 6 the monetary union to establish production within the union. As one outside from firms for attractive more it made also has union etary need for horizontal direct investment. On the other hand, the mon- Thus, reducing the costs associated with trade may actually lead there to and less to neighbouring countries, tends to be a substitute for trade. vestment, such as establishing production in another country for sales in- direct horizontal hand, one the On work. at effects opposing be less clear than those on trade. As discussed in Chapter from not having a national monetary policy. ness cycles with the euro area countries. This would reduce the loss monetary union may in itself lead to greater synchronization of busi- the joining of consequence a as area euro the with trade increased with countries outside the monetary union and the and union monetary the outside countries trade with increased and area euro the within trade from both union, benefit from increased trade by becoming members of the monetary three outsiders, in particular Sweden and the than the average for all euro area countries. with the euro area was somewhat smaller and for the fixed exchange rate against the euro. For Sweden, the increaseselves. inDenmark’s performance trade may reflect the high credibility of the Denmark than the average increase for the euro area countries them- finds that the increase in trade with the euro area has been greater for union, and because euro area exporters become more competitive. more attractive as a trade partner for countries outside the monetary fect could be because monetary union membership makes a country ef- last This countries. other with trade and area euro the with both trade raising trade, on effect positive large fairly a has membership effect varies. On balance, the evidence indicates that monetary union studies find evidence of increased trade, but the size of the estimated ent, which should increase competition. As noted in Chapter exchange rate uncertainty are reduced. Prices become more transpar- positive effect on trade within the union. Currency exchange As costs noted in and Chapter T rade and foreign direct investment 21. The effects of a monetary union on foreign direct investment are Thus, from the evidence in Chapter in evidence the from Thus, For the three outsiders in question, the analysis in Chapter Frankel and Rose (1998). 5, one would expect a monetary union to have a 110 ) ( we would expect that the that expect would we 5 21 uk , would have a clear uk eu 5, there would much smaller . Moreover, . 5 in fact 5, most financial markets. As shown in Chapter in shown As markets. financial The creation of monetary union led to the swift integration of some Financial markets Chapter might expect from opposing effects, the empirical studies surveyed in tne. o eape i dmsi eooi polm ma that mean problems economic domestic if example, For stances. circum- local the to measures adapting for scope more gives bank ment and possibly access to assistance that outsiders do not have. tage in a financial crisis, since it gives some influence in crisis manage- the financial crisis. Being a member of the euro area may betional anbank advan- regulation and supervision, which became evident during suprana - common, for need the country.increases home This their of size the to relation in large become have banks European many cial corporations in Europe. Cross-border banking is increasing, and bility. Bank credit is the major source of debt financing for non-finan- would have limited effects on financial integration for the outsiders. comparison would suggest that membership in the monetary union explained by the difference in central bank interest rates. Overall, the this and Sweden geting in Chapter Figure by shown as union, monetary the within rates mortgage credit markets. For example, there is still considerable dispersion in uity and credit markets, but this is still incomplete, particularly in the are somewhat larger, reflecting the difference in central bank rates. Forrates. interest bank the central in difference the reflect probably differences remaining slight the and area, euro and Sweden have also almost converged with the interest rates in the is very high. However, the interest rates for these assets in Denmark the euro was launched, and integration in the corporate bond market money and public debt markets integrated almost immediately after investment from countries outside. within the euro area, but it may have had positive effects by attracting 5 is that the euro has had little or no effect positive on effect foreign of direct the investment Inner Market. Overall, the conclusion in Chapter studies that find positive effects have not controlled adequately for the One may also argue that having an independent national central An important additional concern is connected with financial sta- Chapter 5 show varying results. However, as argued in Chapter 4. The dispersion for the two outsiders with inflation tar- also shows that some integration has occurred in eq- in occurred has integration some that shows also 4 uk is still greater, but much of this can be can this of much but greater, still is 111 ) ( , Figures 4, uk and 4.1 , the differences the , , the 4.2, 5, the 4.3 111 THE THREE OUTSIDERS AND THE MONETARY UNION 112 chapter 6 in the Governing Council of the of the monetary union? First, of course, the outsiders do not What have do a say the outsiders lose in terms of influence by not beingPolitical issues members yet produce such arguments. rent financial crisis is a tough test for the system, however, and may clear arguments for or against joining the monetary union. The cur- be difficult to address country-specific problems in such a way. cepting a wider range of collateral. Within a monetary union, it might countries, a national central bank may supply additional credit by ac- other in banks than squeeze liquidity tighter a face banks domestic – influence for the countries that have opted out of parts of the discussion and the formation of consensus. has nevertheless assumed more importance over time as a forum for Treaty and does not have any formal decision-making competence. It ecofin regular informal meetings of the finance ministers of the euro area euro the of ministers finance the of meetings informal regular the of policy monetary the on influence the eu bodies, from being less attractive as a partner in the give-and-take of could arise from not being allowed to participate in decision-making that are of specific importance to the outsiders. Such a lossoutside ofthe monetary influence union means less influence on other be small. Rather it would instead seem to be more important if being ers by deliberately abstaining from seeking influence in order to avoid to order in influence seeking from abstaining deliberately by and self-censorship by effect negative the amplify may resentatives rep- involved, areas the in decision-making the outside being from straint on their ability to promote Danish interests. Besides the effect many of the Danish representatives described their opt-outs as a con- all conducted between December from representatives with 20 based on operation, including staying outside the monetary union. One study the Eurogroup – that take place every month the day before the before day the month every place take that – Eurogroup the politics, or simply from reduced reputation. On balance, issues of financial stability seem not to present any present to not seem stability financial of issues balance, On A number of studies have been undertaken to evaluate the loss of Countries outside the monetary union do not participate in the in participate not do union monetary the outside Countries – even the Council meetings. The Eurogroup is not mentioned in the in mentioned not is Eurogroup The meetings. Council 33 in-depth interviews with Danish and British officials and uk – are small relative to the total size of the euro area, eu 112 ) ( ecb bodies and other member states, member other and bodies 2005 and January . However, given that the outsid- ecb would in any case any in would 2008, finds that eu policies eu co - Swedes were clearly overrepresented. the and representation average had British the underrepresented, slightly were Danes the Parliament, the in rapporteurs of tribution Commission, Denmark and the While Swedes were underrepresented in the highest positions in the to important positions in the Parliament or jobs in the Commission. Yes and factor to be considered when choosing cooperation partners (9 said being asked whether the decision to stay outside the euro area was a fourth and seventh place. A clear majority, large countries, France and Germany, with Sweden and Denmark in other two from representatives by followed top, ranked were tives siders were ranked high as cooperation partners. The groups from all ion. In a study of tial than other egy of seeking bilateral cooperation with other member countries. tions, the government, the central bank and other institutions, show holders, representatives from trade unions and employers’ organiza- (2005). the euro area and also happy to contribute to the indicates that study the case, union monetary the In interests. national further to hand, argued that opt-outs in some situations could be used positively suggesting compromises. Some British representatives, on the other and Growth Pact criteria), by helping other member Stability the countries »overfulfill« and Sweden and by Denmark when (as in-class« found to were compensate by outsiders other strategies, the for example However, by being criticism. »best- international or domestic implementation record of their position by trying to be »best in class« and to maintain the best of how good monetary policy should be conducted. 25. 24. 23. 22. The euro-outsiders are not treated unfavourably when it comes it when unfavourably treated not are euro-outsiders The Several studies indicate that the three outsiders are not less influen- Interviews conducted in September Another study finds similarly that Sweden and Denmark improve Grönberg (2003). Lindahl and Naurin (2003). Lindahl and Naurin (2005). Adler-Nissen (2008 ). This is consistent with the findings of Miles and Doherty 8 said Yes regarding euro issues only). uk eu eu representatives are comfortable with being outside countries, in spite of being outside the monetary un- 131 representatives in Council of Minister working member states undertaken in eu directives. 113 ) ( uk were overrepresented. In the dis- 25 2007 with Danish eurostake- 23 They also practise the strat- 102 of 24

2003, the three out- eu 129, said No when 22 on the question

uk representa- 113 THE THREE OUTSIDERS AND THE MONETARY UNION 114 chapter 6 Sweden’s and the the conclusion that this is unlikely to have much effect on Denmark’s, The slow progress on enlargement of the monetary union strengthens but the other new member states are still far away from membership. in Cyprus and Malta member states to join the monetary union. Slovenia joined in tively small economic importance of the newcomers. that the effects are positive, but presumably small in light of the rela- member state’s influence within the union. Overall, one wouldeach reduce also expect would union monetary the within countries more outsiders to exert any influence from the outside. On the other hand, from lower trading costs. It may also make it even more difficult for On the one hand, a larger monetary union would increase the has benefits opposing effects on the question of joining for the three outsiders. In principle, accession of new member states into the monetary union Enlargement of the monetary union able position in Europe. Danish role as a »model country« has also put Denmark in a favour- The situation. the with deal to found been have practices and tions solu- that argued is It union. monetary the outside remaining mark that none of these groups have any immediate problems from Den- allowed to work, fluctuations in the economy are mitigated. Second, and strong automatic stabilizers. When the automatic stabilizers are Chapter in discussed as First, is left to national fiscal policy. what would be best for the individual national economy, stabilization metric shocks imply that the common monetary policy diverges from lization of output, employment and inflation. To the extent that asym- to the state of the economy, and can therefore contribute to the stabi- tary union is that a national monetary policy mone- tends the joining against to argument macroeconomic principal The be better tailored C 26. onclusions It will take more time than originally anticipated for all the new the all for anticipated originally than time more take will It Fiscal policy can play an important role in stabilizing the economy. Marcussen (2007). uk ’s decisions to join for many years. , and Slovakia at the beginning of beginning the at Slovakia and 2008, 26 , most 3, 114 ) ( eu countries have fairly large fairly have countries 2009, 2007, real exchange rate fluctuations which would be beneficial for Sweden and nominal in reduction a to lead to likely therefore is euro the of outsiders have almost half of their trade with the euro area. Adoption ity in the exchange rate towards countries outside the union, the three While membership in a monetary union could result in more volatil- prices and wages are sticky. Such changes are costly for the economy. rate changes lead to real exchange rate changes in the short run since in fundamentals such as such fundamentals in vary considerably in the short run with little or no may rates relation exchange Nominalto removed. changes are union the in countries other the towards fluctuations rate exchange nominal that is union be explained by a too high exchange rate to begin with. roeconomic performance of Germany after competitiveness and that this can take several years. The weak mac- restore to wages and prices correct to difficult is it that shows area land, Portugal and Spain are examples. The evidence from the euro Ire- Greece, increase. productivity of rate higher a by compensate not does it if sector tradeable its of competitiveness the undermine may and inflation for fuel additional provide will This rate. interest real lower a have will inflation average than higher with country A real interest rates since nominal interest rates are more or less equal. in differences to rise give regions or countries between rates flation budget deficits when the debt exceeds the limit. It also sets a limit on the size of the public debt, which further limits deficit. budget public the of size the on limit a sets It Pact. Growth etary union is posed by the restrictions laid down in the Stability and policy tends to be procyclical rather than countercyclical. tion. In fact, the experience in the euro area is that discretionary stabiliza- of demands fiscal the to counter run may which considerations political by influenced economy. often is policy Furthermore,fiscal public purchases that have an adverse effect on the efficiency of the changesinvolve may and fashion timely a in use to and rates tax in harder are policy fiscal in changes Discretionary policy. monetary for substitute imperfect an policy fiscal make that limitations many tercyclical discretionary fiscal policy. However, in practice there are coun- of help the with further economy the stabilise to possible is it The principal macroeconomic argument for joining a monetary a joining for argument macroeconomic principal The An inherent property of monetary union is that differences in in- mon- the in policy fiscal of exercise the for problem specific A gdp and interest rates. Nominalexchangerates. interest and 115 ) ( 1999 can to some extent 115 THE THREE OUTSIDERS AND THE MONETARY UNION 116 chapter 6 would have performed with the euro. Söderström finds that the ing. The difference between the monetary policy rates of Sweden and change rate with the euro, but would probably gain more if it joined. on trade, Denmark has already reaped some gains from its stable ex- country had been a member of the monetary union. As for the effect economic performance would have been essentially the same if the of the euro area. From this we must conclude that Denmark’s macro financial crisis, and its average inflation rate has been the same as that terest rate has closely followed the ing the benefits of a national monetary policy. Its monetary policy in- etary union in mark, Sweden and the Denof - performance the about said be can what here, outlined ion service markets. ency and should therefore serve to promote competition in goods and outsiders. In addition, a single currency will increase price transpar- tween members of the currency union, but also between insiders and be- only not trade, in increase substantial a to led has membership Chapter in evidence The trade. in tuations – indeed from adopting the same currency – is the increase exchange rate against the euro). and the the cyclical position at times. This has led to periods with fairly large in differences sizeable still are there but before, than economy area probably also with countries outside the monetary union. have been considerably higher, in particular with the euro area, but However, the evidence in Chapter be quite small, however. been higher and more volatile and inflation higher. The differences are estimated to etary union would have been quite similar to its actual performance. that Sweden’s macroeconomic performance as a member of the mon- likely seems it Thus, magnitude. similar a of been have and pattern the 27. Sweden has an independent monetary policy with inflation-target- Denmark has pegged its exchange rate to the euro and is not reap- In view of the arguments for and against joining the monetary un- The most important gain from the removal of exchange rate fluc- The ecb gdp This is supported by Söderström (2008 ) who studies how the Swedish economy uk has been fairly small since uk -gap of Sweden and the euro area have followed a similar a followed have area euro the and Sweden of -gap (but not for Denmark since this country already has a fixed economy has become more synchronizedmore become has economy euro the with 1999? uk if they had become members of the mon- 116 ) ( ecb 5 suggests that foreign trade would 1999. This is to be expected since indicates that monetary union monetary that indicates 5 rate, except during the recent gdp growth would have 27

a less favourable budget balance position. Furthermore, relative to relative Furthermore, position. balance budget favourable less a fiscal policy-making. The public budget surpluses. Above all, they have a good framework for monetary policy, since their public debts are low and they have run use fiscal policy as a substitute – albeit imperfect – for an independent to positioned well Swedenare and Denmark present, At equipped. the countries affected. etary union will be resolved, and what the consequences will be for it remains to be seen how the competitiveness problems in the mon- to predict what kind of shocks that will occur in the future. Moreover, the loss from giving up a national monetary policy. It is of course to further reduce hard the extent of asymmetric shocks, thereby reducing economic integration between the outsiders and the insiders is likely the future and on the ability to handle in shockssuch asymmetric of extent shocks.the on depend would Steadily performance increasing the and Sweden for particular in increase, would trade that indicates above evidence The today? being an outsider. enlargement of the monetary union would not have much effect on the Furthermore, small. been have to seems outside staying to due influence political of loss the since affected, much be not probably Sweden and the start. Foreign trade would have increased, however, in particular for and the Sweden Denmark, for different substantially been have not would probably also with countries outside the monetary union. have been considerably higher, in particular with the euro area, but As above, the evidence in Chapter macroeconomic performance of the the on membership union monetary of effect the sharper.Overall, in property prices, most likely making the recent fall in other hand, property a lower interest rate might also have stimulated the surge up inflation, presumably reducing the deviation from target. On the tion was below its target and a lower interest rate would have pushed rate, with the the between differences s o te blt t hnl sok, h oties em well seem outsiders the shocks, handle to ability the for As What can this say about the effects if these countries were to join the and Sweden Denmark, of influence political The n umr, e ocue ht areooi performance macroeconomic that conclude we summary, In uk if they had been members of the monetary union from its uk uk. rate consistently above. For several years, uk uk and the euro monetary policy interest policy monetary euro the and also has a relatively low public debt but 117 ) ( . The effects on macroeconomic on effects The uk. 5 suggests that foreign trade would uk would not have been large. uk uk would prices infla- 117 THE THREE OUTSIDERS AND THE MONETARY UNION 118 chapter 6 exchange rate fluctuations and increased trade on the other. the one hand, and to the likely gain from reduced nominal and real an independent monetary policy in the face of asymmetric shocks on European Commission (2008),emu Dickens, W., L.Goette, E.L.Groshen, S.Holden, J.Messina, M.E. Cukierman, A.andF. Lippi(2001),»Labormarketsandmonetaryunion. Calmfors, L,G.Corsetti, M.P. Devereux, S.Honkapohja, G.Saint-Paul, Calmfors, L.,H.Flam,N.Gottfries, J.H.Matlary, M.Jerneck, R.Lindahl, Bjørnland, H.C.(2006),»Monetary policyandexchange rateovershoot- Andersen, T. M,andJ.Chiriaeva(2007),»Exchange RatePegs, Fiscal Adler-Nissen, R.(2008),»TheDiplomacyofOptingOut:ABourdieudian R for Sweden and the the monetary union. crease. Denmark is therefore likely to gain economically by joining ket loses confidence in the regime. Furthermore, trade is likely to in- shock, it also runs the risk of speculation against the negative krone large if a the of face mar- the in currency its devaluing of option the rate, Denmark has no monetary autonomy. While Denmark retains labor markets, which makes for easier adjustment when necessary. most countries in the euro area, the outsiders have relatively flexible eferenc Journal ofEconomicPerspectives , 21(2),195–214. Micro Evidence from theInternationalWage Flexibilityproject«, Schweitzer, J.Turunen, andM.Ward (2007),»How wageschange: A strategicanalysis«,EconomicJournal111,541–565. european Economy 2007«,Chapter1.ces H-W. Sinn,J-E.Sturm,andX.Vives (2007),»Theeeag A Swedish perspective,KluwerAcademic Publishers. C.N. Berntsson, E.RainowiczandA.Vredin (1997),Monetaryunion– Management. ing: Dornbusch wasrightafterall«,Mimeo,Norwegian School of Policy andCredibility«,OpenEconomicsReview18,53–76. 101, 241–256. ScandinavianJournalofEconomics sation, policytargets,andunemployment. Approach toNational Bratsiotis«,iG.J.andC.Martin(1999),Stabili- Whether joining the monetary union is economically beneficial economically is union monetary the joining Whether Should Denmark, Sweden and the e s uk depends on what weight is given to the loss of 118 ) ( @ten. uk join? With a fixed exchange ifo. Report onthe Marcussen, M.(2007),Handlingeuro-outsiderness, Center forDemocratic Marcussen, M(2005),»Denmark andEuropeanMonetary Integration: Lindahl, R.andD.Naurin (2005),»Sweden: TheTwin Faces ofaeuro- Lindahl, R.andD.Naurin (2003),»Gemenskap, utanförskapoch Holden, S.andF. Wulfsberg (2008),»Downward nominalwagerigidity Holden, S.(2005),»Monetary- regimesandtheco-ordinationofwageset Grönberg, M.(2003),»Monetary unionryktetoch inflytandet«,Mimeo, Frankel, J.andA.Rose (1998),»TheEndogeneityofOptimalCurrency Söderström, U.(2008),»Re-evaluating Swedish Membership inthemon- Soskice, D.andT. Iversen (2000 ), »Thenon-neutralityofmonetarypolicy Soskice, D.andT. Iversen (1998),»Multiplewage-bargainingsystemsin Rigobon, R.(2008),»Exchange ratevolatility«,inDurlauf,S.N.andL.E. Puetter, U.(2004),»Governing informally:theroleofeurogroupin Pisani-Ferry, J,P. Aghion,M.Belka, J.vonHagen,L.Heikensten, and Miles, LeeandGabrielDoherty (2005).»TheUnitedKingdom:ACau- Network Governance, Roskilde University,wp Out ButFar From Over«, European Integration, Vol. 27,No. 1, 43–63. Outsider«, European Integration, Vol. 27,No. 1,65–87. No. 03:2,Göteborg. inflytande ieu (Advances), Article15. in theoecd ting«, European EconomicReview49,833–843. University ofGothenborg, Department ofPolitical Science. Area Criteria«,TheEconomicJournal108,1 University. etary union:Evidence fromanEstimatedModel«, Mimeo,Bocconi 265–284. with largepriceorwagesetters«,QuarterlyJournalofEconomics cxv 14, 110–124. the singleeuropeancurrencyarea«,OxfordReviewofEconomicPolicy Blume (eds.),TheNewPalgrave DictionaryofEconomics,Vol. 3,96–99. pean PublicPolicy 11:5,854–870. monetary unionandtheStabilityGrowthPact«, JournalofEuro- Blueprint Series. A. Sapir(2008),»Coming ofage:Report ontheeuroarea«,Bruegel European Integration, Vol.tious euro-Outsider«, 27,No. 1,89–109. The B.E. JournalofMacroeconomics, Vol.«, TheB.E. 8(2008),Iss.1 :s Ministerråd«,Göteborg.cergu 119 ) ( 009–1 2007:6. Working Paper Series, 025. , 119 THE THREE OUTSIDERS AND THE MONETARY UNION ( 120 ) Antonio Fatás is the Portuguese Council Chaired Professor of Econom ics at 121 insead, France. His research covers areas such as the macroeconomic effects of fiscal policy, and the connections between business cycles and growth. He has worked as an external consultant for the imf, the World Bank, the oecd and the European Commission. Antonio Fatás is the principal author of the chapter on fiscal policy (together with Ilian Mi- hov). Harry Flam is Professor of International Economics at the Institute for Inter- national Economic Studies, Stockholm University. His research mainly covers the theory of international trade and trade policy, and economic integration. He was a member of the Swedish government’s commission that investigated Sweden’s accession to the monetary union. He has also been a member of the government’s Economic Council. Harry Flam is the principal author of the chapter on trade and foreign direct investment. Steinar Holden is Professor of Macro and Monetary Policy Issues at the s

Department of Economics, University of Oslo. His recent research has r

mostly dealt with wage rigidity and monetary regimes. He has headed o h

three government commissions on issues related to macroeconomics, t wage setting and the labor market, and he has twice evaluated the Nor- a u wegian monetary policy as member and head of Norges Bank Watch. Steinar Holden is the principal author of the chapter on the three outsiders, Denmark, Sweden and the uk. Tullio Jappelli is Professor of Economics at the University of Naples Fed- erico ii and heads its Center for Studies in Economics and Finance. His main areas of research are savings, liquidity constraints and household portfolio choice. He is Editor of the journal Economic Policy and has been a consultant to the World Bank and the European Commission, among others. Tullio Jappelli is the principal author of the chapter on financial integration (with Marco Pagano). Ilian Mihov is Professor of Economics and the Novartis Chaired Profes- sor of Management and Environment at insead, France, and has a research professorship at dwi in Berlin. His research is primarily in the fields of monetary and fiscal policy, economic growth, trade diversification, and political economy. He is a consultant to the Banque of France on research issues, the Bulgarian central bank and the monetary authority of Singapore. Ilian Mihov is the principal author of the chapter on fiscal policy (with Antonio Fatás).

Cont.

( 121 ) 122 Marco Pagano is Professor of Economics at University of Naples Federico ii and heads the Einaudi Institute for Economics and Finance. His research covers macroeconomics, monetary and fiscal policy, and financial markets. He has been a consultant to the Italian ministry of finance, the European Commission, the ecb, and others. Marco Pagano is principal author of the chapter on financial integration (with Tullio Jappelli). Charles Wyplosz is Professor of International Economics at the Graduate Institute in Geneva, where he is Director of the International Centre for Money and Banking Studies. His main research areas include financial crises, European monetary integration, fiscal policy, economic transition and current regional integration in various parts of the world. He is currently a member of the Group of Independent Economic Advisors to the President of the European Commission, and has been an advi- sor to the imf, World Bank, United Nations, among others. Charles Wyplosz is the principal author of the chapter on monetary policy. AUTHORS

( 122 ) ( 123 ) ( 124 )