GLOBAL SGH European Economics

The economics of monetary union. Optimum currency areas (OCA) and the European Central Bank in action.

European Economics – The economics of monetary union. Optimum… 1. The road to European Monetary Union (EMU). 2. The convergence criteria. 3. Monetary policy under EMU. 4. Single currency – impact on business. 5. Optimal currency areas – the theory and practice. 6. The EMU criteria and the Stability Pact.

European Economics – The economics of monetary union. Optimum… The road to EMU EMU is the latest step on the road towards greater integration in Europe. Monetary union in the European Community (EC) was proposed as long ago as 1970 in the Werner Report, which envisaged it being in place by 1980.

European Economics – The economics of monetary union. Optimum… The road to EMU However, two key developments in the international sphere derailed this first attempt: 1. The breakdown of the Bretton Woods system of fixed exchange rates in August 1971, and 2. The 1973 oil crisis.

European Economics – The economics of monetary union. Optimum… The road to EMU The first attempt by the EC to deal with the exchange rate turbulence that followed both of these events, the so-called “snake,” rapidly collapsed to an arrangement involving only a few of the Member States.

European Economics – The economics of monetary union. Optimum… The road to EMU The second attempt, the European Monetary System* (EMS), created in 1979, proved more durable, although it too was accompanied by a number of major and minor crises. * Main elements: Exchange Rate Mechanism + ECU

European Economics – The economics of monetary union. Optimum… The road to EMU “..... let me make clear, from the outset, that monetary union is fundamentally a political rather than an economic issue. It necessarily involves the deliberate pooling of national sovereignty over important aspects of public policy, in the interest not just of collective economic advantage, but of a perceived wider political harmony within Europe.” Governor of the Bank of England, 2000

European Economics – The economics of monetary union. Optimum… The road to EMU The Treaty did three things to further monetary integration in Europe. 1. It set out a timetable for the establishment of monetary union. 2. It laid down the criteria by which the fitness of countries to join in monetary union would be determined. 3. It established the institutional framework for the conduct of monetary policy under EMU.

European Economics – The economics of monetary union. Optimum… The three stages of monetary union Stage One: July 1, The complete elimination of capital controls among the Member States and increased cooperation between their central banks. Stage Two: January 1, The real beginning of the transition to EMU with the establishment of the European Monetary Institute (EMI). EMI = precursor of the European Central Bank, charged with co-ordinating monetary policy and preparation for the single currency.

European Economics – The economics of monetary union. Optimum… The three stages of monetary union Stage Three: January 1, Eleven countries fixed their exchange rates. The national currencies of the eleven were replaced by the euro. The ECB took over responsibility for monetary policy in the euro area.

European Economics – The economics of monetary union. Optimum… The three stages of monetary union Stage Three A: The initial period of monetary union during which the notes and coins of each of the participating states continue to circulate as non-decimal representations of the euro. Stage Three B: Begins with the introduction of euro notes and coins and the withdrawal of national currencies on January 1, By July 1, 2002 the old national currencies ceased to have legal tender status.

European Economics – The economics of monetary union. Optimum… The convergence criteria Essentially all of the EU members satisfied the bulk of the criteria for participation in EMU. However, Denmark and the United Kingdom did not participate in the first round, having negotiated “derogations”, even though they satisfied most of the criteria.

European Economics – The economics of monetary union. Optimum… The convergence criteria Likewise Sweden did not participate. The only country that wished to participate but failed to meet the convergence tests was Greece (joined in 2001) New member states need to meet euro acquis and Slovenia, Malta, Cyprus and Slovakia have now joined the EMU, too.

European Economics – The economics of monetary union. Optimum… Monetary policy under EMU EMU fundamentally changes the way in which monetary policy is conducted in the participating states. Responsibility for monetary policy shifted from national central banks to the ECB on January 1, 1999.

The European System of Central Banks (ESCB) Graph no. 1

The European System of Central Banks (ESCB) Graph no. 2

The European System of Central Banks (ESCB) Graph no. 3

European Economics – The economics of monetary union. Optimum… Is the common currency suitable and good for your economy? Are business cycles and economic structures compatible so that we and others could live comfortably with euro interest rates on a permanent basis? If problems emerge is there sufficient flexibility to deal with them? Would joining EMU create better conditions for firms making long-term decisions to invest in your country?

European Economics – The economics of monetary union. Optimum… Is the common currency suitable and good for your economy? What impact would entry into EMU have on the competitive position of your country’s financial services industry? In summary, will joining EMU promote higher growth, stability and a lasting increase in jobs?

European Economics – The economics of monetary union. Optimum… Single currency – impact on business The euro means big changes for business both within these countries and throughout Europe: Cheaper transaction costs – countries in the euro zone do not have to change currencies when doing business with each other. Exchange rate certainty – sharing a single currency means countries in the euro zone are no longer affected by currency fluctuations when trading with each other.

European Economics – The economics of monetary union. Optimum… Single currency – impact on business Transparent price differences – it is more obvious if different euro zone countries charge different prices for the same goods and services. Increased cross-border competition – businesses who want to export into the euro zone may be at a disadvantage against competitors within the zone who share the same currency as the importer.

European Economics – The economics of monetary union. Optimum… Single currency – impact on business Cross-border mergers and other joint ventures – increased competition might make mergers within the euro zone more likely, and sharing the single currency may also make them easier. Distribution and purchasing – may become simpler and cheaper inside the euro zone, because businesses there will not have to worry about exchange rate risk when trading with each other.

European Economics – The economics of monetary union. Optimum… Single currency – impact on business Raising finance – Firms may have more choice since bond and equity markets may be more attractive in euros. Pricing – companies may have to decide whether to set new pricing points. The same price is unlikely to be as ‘attractive’ in euros as in the old national currencies.

European Economics – The economics of monetary union. Optimum… Optimal currency areas – the theory and practice Why not a worldwide currency? The main issue are asymmetric shocks Questions arising: –How do they create trouble? –What makes them more likely? –What makes them less painful? (OCA theory)

European Economics – The economics of monetary union. Optimum… Optimal currency areas – the theory and practice The Maastricht Treaty emphasised the importance of achieving a high degree of sustainable convergence, if a country is to participate in EMU. When outside economic shocks do arise, their impacts are often felt asymmetrically. For countries outside a monetary union, this should not pose a problem as exchange rate flexibility can deal with such shocks.

European Economics – The economics of monetary union. Optimum… Optimal currency areas – the theory and practice Inside the EMU, on the other hand, a substantial degree of business-cycle convergence would be highly desirable. If all economies in the union had the same business cycle, then the ECB could afford to use monetary policy as a stabilization tool. However, a divergence in economic growth rates throughout the region tends to cause the ECB to conduct a more cautious monetary policy.

European Economics – The economics of monetary union. Optimum… Optimal currency areas – the theory and practice The crucial point with respect to monetary unions, such as the EMU, is that in the absence of flexible exchange rates, there must be flexibility elsewhere, such as labour market flexibility or mobility.

European Economics – The economics of monetary union. Optimum… Optimal currency areas – the theory and practice Conditions necessary for a successful OCA: 1. A high degree of factor mobility (Mundell). 2. Open trade and a high degree of trade between regions/states (McKinnon).

European Economics – The economics of monetary union. Optimum… Optimal currency areas – the theory and practice Conditions necessary for a successful OCA: 3. Countries whose production and exports are widely diversified and of similar structure (Kenen) 4. Countries agree to compensate each other for adverse shock from an OCA (fiscal transfers) 5. Broadly similar attitudes to macro-economic policy (also: common destiny…)

European Economics – The economics of monetary union. Optimum… The EMU criteria Criteria for Stability: 1. Budget Deficit ≤ 3% of GDP 2. National Debt ≤ 60% of GDP 3. Inflation not > by 1.5% than average of best 3 states 4. Interest rates not > by 2% than average of best 3 states

European Economics – The economics of monetary union. Optimum… The Stability Pact Objective: Convergence as a permanent rule Elements: –Definition of excessive deficits and exceptions –Warning and correction mechanism –Sanctions

European Economics – The economics of monetary union. Optimum… Criteria for complete EMU The removal of all barriers to capital transfer. Fiscal Harmonisation and transferability of welfare rights (pensions, national insurance contributions, etc). A central bank at the European level to centralise transfers, monitor policy and enforce banking regulations equitably throughout the Community.

European Economics – The economics of monetary union. Optimum… Criteria for complete EMU A single currency acceptable in all members states (or acceptance of all currencies in all states - a UK proposal). The parameters of macro-economic policy will be determined at the European level. Individual governments will set targets for interest rates, monetary growth, public expenditure.

European Economics – The economics of monetary union. Optimum… Is Europe an OCA? Effect of a 1% point interest rate increase on GDP level and prices in EU countries graph

European Economics – The economics of monetary union. Optimum… Is Europe an OCA? Most EU countries have a diversified production structure (intra-industry trade dominates) The Kenen criterion is broadly satisfied and well explains which countries joined the euro area. The EU does not satisfy the transfer criterion. The overall EU budget: – is low, capped at 1.24% of EU GDP –entirely used for administration, CAP, regional and structural funds.

European Economics – The economics of monetary union. Optimum… Advantages of EMU eliminating conversion costs increased competition elimination of exchange-rate uncertainty between members increased inward investment lower inflation and interest rates no need for reserves regional convergence returns to scale of one currency

European Economics – The economics of monetary union. Optimum… Disadvantages of EMU not an optimal currency area? asymmetric shocks regional problems political arguments monetary policy loss

European Economics – The economics of monetary union. Optimum… In the end Monetary union is not only about economics (!?) The OCA criteria do not send a clear signal: –the EU is not a perfect OCA –a monetary union may function, at a cost: –labour markets and unemployment –political tensions in presence of deep asymmetric shocks.

GLOBAL SGH European Economics