Economic and monetary union (EMU)

EMU involves … Policy harmonisation to remove obstacles to factor mobility A more marked and wider range of common policies, especially in relation to macroeconomic policy Irrevocably fixed exchange rates or, as in the case of the EU, a single currency A common monetary policy – that is, one interest rate and exchange rate policy determined by a single Central Bank Some pooling of foreign exchange reserves Possible inter-state transfers to offset economic distortions arising from EMU

A bit of theory To be an EMU the EU needs to be an Optimal Currency Area This means that there has to be: o an absence of asymmetric shocks o a high degree of labour mobility and wage flexibility o a centralised fiscal policy that can redistribute resources to member countries performing poorly

The road to EMU EMU is long standing objective Starting in 1970s Evolved from European Monetary System (EMS) (a semi-fixed exchange rate system) EMS often unstable but was platform for EMU Led to Maastricht Treaty – three stage approach

Three stage approach Stage One (from 1 July 1990) the removal of all remaining obstacles to capital flows the participation of all member states’ currencies in the ERM and greater policy co-ordination and convergence of economic performance Stage Two (from 1 January 1994) creation of the European Monetary Institute (EMI), a transitional institution intended to be replaced by the European Central Bank (ECB). During this stage, any central bank that was not already independent of its national government, was to become independent Stage Three (from1 January 1999) the irrevocable fixing of participating currencies. The European System of Central Banks (ESCB), composed of the European Central Bank and independent national banks, took over responsibility for monetary and exchange rate policy

Convergence is key Nominal convergence Real convergence Institutional convergence

Costs and benefits of EMU Benefits elimination of intra-EU transaction costs lower interest rates uniform interest rates removal of exchange rate uncertainty in intra-EMU trade aids development of a genuine SEM removes the option of competitive devaluations between EU states financial integration economic cushioning from domestic political instability creates a new international currency to represent the EU’s combined economic weight Costs short term deflation loss of the exchange rate as a tool of national economic policy loss of power to set interest rates and control the supply of money potential problems related to a lack of ‘real’ convergence and potential policy conflicts the inappropriateness of one monetary policy for so many states

EMU – the first decade A mixed record due to: o The ineffectiveness of the Stability and Growth Pact (SGP) as a bulwark against fiscal profligacy o The unwillingness of some member states to take the necessary micro-economic reform

The Euro crisis (from 2009) Failure to reform and inadequate convergence was core to crisis As was ill-designed system Deterioration of public and current account balances Portugal, Greece, Ireland and Spain Contagion in system as banking crisis turned into public debt crisis

The Euro crisis (from 2009) Expose fault lines in Euro Austerity vs. growth Application of German ordo-liberalism – not easily transferable EU growth fell and unemployment rose sharply

Main problems of EU as an OCA Labour mobility is limited across the EU There is a home bias in capital markets Wage and prices tend to be inflexible downwards There is no substantive internal fiscal transfer mechanism Business cycles are not fully synchronised across the eurozone Economic structures across the EU are still divergent

EU had co-ordination problem This led to: Excessive borrowing Conflict over responsibility over bail outs Divergent macro-economic policies Divergent economic growth patterns The implications of trade imbalances

Solutions Short term o Quantitative easing o Bail out o Financial assistance Long term o Economic reforms o Reform of EMU o Fiscal centralisation