1. TU-91.E1160 International Economics by Hannele Wallenius
5 MONETARY UNIONS

2. 5 MONETARY UNIONS 5.1 EMU 5.2 Optimal Currency Areas
5.3 Cost of Common Currency

3. What is a monetary union?
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).

4. 5.1 EMU (Economic and Monetary Union)
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.
The euro is the single currency shared today by 19 of the European Union's Member States, which together make up the euro area.

5. The introduction of the euro was a major step in European integration.
The decision to form an Economic and Monetary Union was taken by the European Council in Maastricht in December 1991.
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
The birth of the Euro resulted in fixed exchange rates between all EMU member countries.
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

6. Who can join and when?
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’.

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

9. 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.

10. 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.

11. To turn the European Union into truly unified market...
free trade in goods
free trade in services
free mobility of capital
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.

12. Why was EMS not enough?
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.

13. Why was EMS not enough? continued
2. Some EU leaders feared too large of a dominance of German Bundesbank emphasizing German macroeconomic goals.
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.

14. 5 MONETARY UNIONS 5.1 EMU 5.2 Optimal Currency Areas
5.3 Cost of Common Currency

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

16. OCA Criteria Extent of trade Similarity of shocks and business cycles
Degree of labor mobility
System of fiscal transfers

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

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

19. Benefits and Costs of Monetary Integration
Lines B and C represent the benefits and costs of the monetary integration, respectively. E is the point where benefits = costs. 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. H*
Costs,
Benefits B E
E* is reached after
monetary integration. E* C C*
Trade/GDP ratio
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.

20. 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 (for instance, capital and skilled labor in north).

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

22. Is the EMU an OCA? Continued
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.

23. Is the EMU an OCA? Continued
It seem that Europe is not an optimal currency area!
Published 12 Dec, 2016
Euro was a mistake,' says Nobel Prize-winning economist (Oliver Hart)
Hart’s prize-winning colleague Bengt Holmström said the EU needs to “redefine its priorities, limiting its activities and its regulatory arm, to focus on what can be done on the essential things.”
The Finnish economist and a professor at the MIT, Holmström, said the EU has to "do something" with its governance system and its ground rules to make it “clearer and simpler.”

24. 7 MONETARY UNIONS 5.1 EMU 5.2 Optimal Currency Areas
5.3 Cost of Common Currency

25. 5.3 Cost 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:

26. A Two Country Monetary Union
Let's assume that consumers shift their preferences away from Finnish-made to German-made products: ADF  and ADG .
Finland
Germany PF PG
ASF
ASG
ADG
ADF YF YG

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

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

29. Wage flexibility would shift the aggregate supply curves of the countries in opposite directions bringing countries back towards the equilibrium.
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.

30. Wage flexibility: 1) ASF  and ASG  and 2) the second-order effect would shift AD-curves, respectively.
Finland
Germany PF PG
ASG’
ASF
ASG
ASF’
ADG
ADF YF YG

31. Labor mobility would eliminate the need for wage rate changes, instead Finns simply would move to Germany to work!
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.

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

33. 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…

34. Addressing Europe's economic and political challenges
Brexit is just one example of the political problems Europe is facing. Globalization and international cooperation is currently challenged in many places…
A broad debate is under way about the European Union’s raison d’être and its future.
Establishing of a single European market was never solely about economic efficiency. It was also about creating a free and open European society under a common rule of law.

38. Many vocal demands of EU exits (True Finns, Le Pen, Wilders etc.

39. How are the politicians trying to fix the EMU?
Let’s first look what was said already at the beginning of EMU.
Then let’s look at the fixes proposed.

40. Let’s take a look back. Note this is from 1999:
The Future of EMU: What Does the History of Monetary Unions Tell Us? NBER Working Paper No. 7365, September 1999
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.

41. Do these 'flaws' represent major threats to the future of EMU?
NBER Working Paper No. 7365, September 1999, continued…
Do these 'flaws' represent major threats to the future of EMU?
Or will they be successfully resolved by the European policy authorities, leading to a lasting and prosperous EMU?
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.

42. Design Faults of EURO Project (by Philip Arestis, Malcolm Sawyer, 2011)
Note, now we turn to more current situation.
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.
And how about productivity differences?

43. After the Euro crises escalated commission proposes new ECB powers for banking supervision as part of a banking union.
What is a Banking Union?

44. Steps towards a banking union:
On 12 Sep the Commission proposed a single supervisory mechanism (SSM) for banks led by ECB in order to strengthen EMU.
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.
On 19 Dec council agrees general approach on Single Resolution Mechanism (SRM). Negotiations with the European Parliament started in early 2014 to allow for its adoption before the end of the current legislative period.
As from November 4, 2014 major Eurozone banks are under a single supervision of the European Central Bank (ECB).
In November 2015 the Commission proposed to set up a European deposit insurance scheme (EDIS) for bank deposits in the euro area. EDIS is the third pillar of the banking union.
As of Jan. 2016, all eurozone member states participate in the SRM.