Aalto University School of Science Department of Industrial Engineering and Management TU-91.E1160 International Economics by Hannele Wallenius 5 MONETARY UNIONS

International Economics Hannele Wallenius 5MONETARY UNIONS n 5.1 EMU n 5.2 Optimal Currency Areas n 5.3 Cost of Common Currency 2

International Economics Hannele Wallenius What is a monetary union? n Two or more countries with a single currency, or different currencies having a fixed mutual exchange rate monitored and controlled by one central bank (or several central banks with closely coordinated monetary policies).countriescurrenciesmutualexchange ratecentral banks monetary policies 3

International Economics Hannele Wallenius 5.1 EMU (Economic and Monetary Union) n Economic and Monetary Union (EMU) represents a major step in the integration of EU economies:  It involves the coordination of economic and fiscal policies,  a common monetary policy, and  a common currency, the euro. n The euro is the single currency shared today by 19 of the European Union's Member States, which together make up the euro area. 4

International Economics Hannele Wallenius The introduction of the euro was a major step in European integration. n The decision to form an Economic and Monetary Union was taken by the European Council in Maastricht in December n On January 1, 1999* eleven member countries of EU adopted a common currency (‘book money’).  2001 Greece, 2007 Slovenia and Cyprus, 2008 Malta, 2009 Slovakia, 2011 Estonia, 2014 Latvia, and 2015 Lithuania joined the EMU; Romania targeting joining n The birth of the Euro resulted in fixed exchange rates between all EMU member countries. n By giving up national currencies they handed over control of their monetary policies to ECB. *EMU was established in three phases: coordinating economic policy, achieving economic convergence (!?) and culminating with the adoption of euro as physical money

International Economics Hannele Wallenius Who can join and when? n All Member States of the European Union, except Denmark and the United Kingdom, are required to adopt the euro and join the euro area. To do this they must meet certain conditions known as 'convergence criteria’. n htm 6

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International Economics Hannele Wallenius How and why did Europe set up its single currency? n War-torn history of Europe is the main contributor for both the market and monetary unification. n After the Bretton Woods system’s breakdown (1971) currencies, in principle, floated freely against dollar. 8

International Economics Hannele Wallenius n EU countries, however, progressively tried to narrow the extent to which they let their currencies fluctuate against each other. Warner committee (1969) started the drive toward European monetary policy*. The “snake”, a European informal joint float against dollar. European Monetary System (EMS) , a formal network of mutually pegged exchange rates (ERM). * Interestingly, already in the League of Nations, Gustav Stresemann asked in 1929 for an European currency because of an increased economic division due to a number of new nation states in Europe after the Treaty of Versailles. 9

International Economics Hannele Wallenius Two Main Motives for Single Currency: 1.To enhance Europe’s role in the world monetary system. EU countries hoped to defend more effectively their economic interests in the face of an increasingly self-absorbed US. 2. To turn the European Union into truly unified market. It was believed that exchange rate uncertainty was a major factor reducing trade within Europe. 10

International Economics Hannele Wallenius To turn the European Union into truly unified market... n free trade in goods n free trade in services n free mobility of capital n free mobility of labor Market competition leads to common prices across the union, which leads to optimal allocation of resources increasing welfare and economic growth. Building blocks of an integrated competitive market. BUT existence of separate national currencies, often subjects countries to erratic exchange rate changes, causes random price fluctuations which disturb the integration process. 11

International Economics Hannele Wallenius Why was EMS not enough? 1.Single currency was believed to produce a greater degree of European market integration than fixed exchange rates.  By removing the threat of EMS currency realignments and eliminating the cost of converting one EMS currency into another. 12

International Economics Hannele Wallenius Why was EMS not enough? continued 2. Some EU leaders feared too large of a dominance of German Bundesbank emphasizing German macroeconomic goals. 3.Given the free capital movements, maintaining fixed exchange rates single currency was the best solution. 4. Political stability of Europe. single currency seen as a potent symbol of Europe’s desire to place cooperation ahead of the national rivalries that often had led to war in the past. 13

International Economics Hannele Wallenius 5 MONETARY UNIONS n 5.1 EMU n 5.2 Optimal Currency Areas n 5.3 Cost of Common Currency 14

International Economics Hannele Wallenius 5.2 Optimum Currency Areas n Theory originally developed by Robert Mundell in 1961: Fixed exchange rates within a region, floating between regions. n According to the theory of OCA, fixed exchange rates are most appropriate for areas closely integrated through international trade and factor movements. 15

International Economics Hannele Wallenius OCA Criteria n Extent of trade n Similarity of shocks and business cycles n Degree of labor mobility n System of fiscal transfers 16

International Economics Hannele Wallenius Benefits of a Monetary Union n Elimination of transaction costs of changing one currency into another in inter-country trade n Transparency of prices  Increased competition n Reduced exchange rate uncertainty  Elimination of hedging costs  Risk-averse parties engage in more trade n Low inflation, standardization of interest rates n Increased policy credibility from the elimination of devaluations. 17

International Economics Hannele Wallenius Costs of a Monetary Union n Loss of national monetary policy n If wage inflexibility and labor immobility unemployment and inflation n Different labor market structures n Raising (government) revenue through inflation not possible any more. n Switching costs  administrative, legal, hardware  psychological n Wrong fixed rate 18

International Economics Hannele Wallenius Benefits and Costs of Monetary Integration n Lines B and C represent the benefits and costs of the monetary integration, respectively. E is the point where benefits = costs. Costs, Benefits Trade/GDP ratio C B H E E* H* Through time increased competition in a common market (induced by factor movement, price flexibility, increased trade) will lead decreased costs and increasing potential benefits of the union. Line H through E divides the are of the diagram into two sectors: to the left of H, the costs exceed the benefits, C > B; and visa versa to the right of H. So a country should be on the right of H to joint the union. E * is reached after monetary integration. C* 19

International Economics Hannele Wallenius n But, on the other hand, we can view the potential structural dissimilarity of the union partners as shifting the CC schedule upwards, rising the degree of economic integration required before membership in the currency union becomes a good idea.  Note the dissimilarities of northern Europe and southern Europe in factor endowments (capital and skilled labor in north). 20

International Economics Hannele Wallenius Is the EMU an OCA? n Openness and diversification large trade to GDP ratios intra-EMU trade n Similarity of shocks? Examples of asymmetric shocks: –unification of Germany –the collapse of Soviet union –current debt crises in EU… 21

International Economics Hannele Wallenius Is the EMU an OCA? Continued n Labor mobility greatly insufficient! ￭ System of fiscal transfers no formal system as of yet, but what will the ESM (European Stability Mechanism)* bring along? *ESM is a permanent crisis resolution mechanism for the euro area. The ESM issues debt instruments in order to finance loans and other forms of financial assistance to euro area Members States. 22

International Economics Hannele Wallenius Is the EMU an OCA? Continued n It seem that Europe is not an optimal currency area yet! 23

International Economics Hannele Wallenius 7 MONETARY UNIONS n 5.1 EMU n 5.2 Optimal Currency Areas n 5.3 Cost of Common Currency 24

International Economics Hannele Wallenius 5.3Cost of a Common Currency: An Illustration  How to cure asymmetric shocks?  Devaluation or revaluation of a currency in EU trade is not possible any more... neither can we determine the quantity of national money in circulation, i.e. we have lost the ability to conduct a national monetary policy. Let’s take an example of asymmetric shocks: 25

International Economics Hannele Wallenius A Two Country Monetary Union AS F AS G AD F AD G YFYF YGYG PFPF PGPG FinlandGermany n Let's assume that consumers shift their preferences away from Finnish-made to German- made products: AD F  and AD G . 26

International Economics Hannele Wallenius n Both countries will face an adjustment problem: 1)Finland is plagued by unemployment and current account deficit. 2)Germany experiences a boom  inflation and current account surplus. 27

International Economics Hannele Wallenius Cost of a Common Currency continued n Is there a mechanism that leads to an automatic equilibrium without devaluation/revaluation? n YES, if there is: 1) wage flexibility 2) labor mobility 28

International Economics Hannele Wallenius n Wage flexibility would shift the aggregate supply curves of the countries in opposite directions bringing countries back towards the equilibrium. n There would also be second-order effects on aggregate demand: wages and prices in Germany would increase making Finnish products more competitive and so increasing AD in Finland and decreasing AD in Germany. 29

International Economics Hannele Wallenius AS F AS G AD F AD G YFYF YGYG PFPF PGPG FinlandGermany n Wage flexibility: 1) AS F  and AS G  and 2) the second-order effect would shift AD-curves, respectively. 30 AS G ’ AS F ’

International Economics Hannele Wallenius n Labor mobility would eliminate the need for wage rate changes, instead Finns simply would move to Germany to work! n But if wage flexibility and/or labor mobility are not sufficiently high the adjustment problem will not vanish.  Instead now the adjustment to the disequilibrium will take the form of inflation in Germany. 31

International Economics Hannele Wallenius n And if German authorities do care of inflation, they want to resist these inflationary pressures (by restrictive monetary and fiscal policies). n But their current account problems will not disappear. n Revaluation in Germany or devaluation in Finland would solve this dilemma, but that’s now impossible! 32

International Economics Hannele Wallenius n Can we solve the dilemma by using some other instruments? In principle, yes: Germany could increase taxes to reduce its aggregate demand and transfer these revenues to Finland where they would be spent to increase Finnish aggregate demand !!!! This would mean federalism in EU… 33

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International Economics Hannele Wallenius How are the politicians trying to fix the EMU? n Let’s first look what was said already at the beginning of EMU. n Then let’s look at the fixes proposed. 38

International Economics Hannele Wallenius The Future of EMU: What Does the History of Monetary Unions Tell Us? NBER Working Paper No. 7365, September 1999 n The creation of EMU and the ECB has triggered a discussion of the future of EMU. Independent observers have pointed to a number of shortcomings or hazard areas' in the construction of EMU:  Absence of a central lender of last resort function for EMU.  The lack of a central authority supervising the financial systems of EMU.  Unclear and inconsistent policy guidelines for the ECB.  The absence of central co-ordination of fiscal policies within EMU.  Unduly strict criteria for domestic debt and deficits, as set out in the Maastricht rules, in the face of asymmetric shocks, and Euroland not being an optimal' currency area. 39 Let’s take a look back. Note this is from 1999:

International Economics Hannele Wallenius NBER Working Paper No. 7365, September 1999, continued… Do these 'flaws' represent major threats to the future of EMU? n Or will they be successfully resolved by the European policy authorities, leading to a lasting and prosperous EMU? n Our main lesson from the history of monetary unions is that political factors will be the central determinants of the future of EMU. The 'economic' shortcomings of EMU will likely be overcome as long as political unity prevails within EMU. 40

International Economics Hannele Wallenius Design Faults of EURO Project (by Philip Arestis, Malcolm Sawyer, 2011)Philip ArestisMalcolm Sawyer n Convergence criteria focus on nominal rather than real variables and pay no attention  to the validity of the exchange rates at which countries enter the EMU,  or to the prevailing current account deficits and surpluses,  nor to the differences in inflation mechanisms between countries,  inadequacy of a fiscal policy based on numerical targets operating at the national level. 41 Note, now we turn to more current situation.

International Economics Hannele Wallenius Commission proposes new ECB powers for banking supervision as part of a banking union n On 12 Sep the Commission proposed a single supervisory mechanism (SSM) for banks led by ECB in order to strengthen EMU. n First step towards an integrated “banking union” which includes further components such as a single rulebook, common deposit protection and a single bank resolution mechanisms. n On 19 Dec council agrees general approach on Single Resolution Mechanism (SRM). Negotiations with the European Parliament will start in early 2014 to allow for its adoption before the end of the current legislative period. n As from November 4, 2014 major Eurozone banks are under a single supervision of the European Central Bank (ECB). And now we are here… 42 Banking Union applies to countries in the euro-area. Non-euro-area countries can also join.

International Economics Hannele Wallenius What is a Banking Union Us