1. Chapter 20: Optimum Currency Areas and the European Experience
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2. Chapter Organization How the European Single Currency Evolved
The Euro and Economic Policy in the Euro Zone
The Theory of Optimum Currency Areas
The Future of EMU
Summary
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3. Introduction
European Union countries have progressively narrowed the fluctuations of their currencies against each other.
This culminated in the birth of the euro on January 1, 1999.
This chapter focuses on the following questions:
How and why did Europe set up its single currency?
Will the euro be good for the economies of its members?
How will the euro affect countries outside of the European Monetary Union (EMU)?
What lessons does the European experience carry for other potential currency blocks?
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4. How the European Single Currency Evolved
Table 20-1: A Brief Glossary of Euronyms
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15. How the European Single Currency Evolved
European Currency Reform Initiatives,
The Werner report (1969)
It set out a blueprint for the stage-by-stage realization of Economic and Monetary Union by proposing a three-phase program to:
Eliminate intra-European exchange rate movements
Centralize EU monetary policy decisions
Lower remaining trade barriers within Europe
Two major reasons for adopting the Euro:
To enhance Europe’s role in the world monetary system
To turn the European Union into a truly unified market
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16. How the European Single Currency Evolved
The European Monetary System,
Germany, the Netherlands, Belgium, Luxemburg, France, Italy, and Britain participated in an informal joint float against the dollar known as the “snake.”
Most exchange rates could fluctuate up or down by as much as 2.25% relative to an assigned par value.
The snake served as a prologue to the more comprehensive European Monetary System (EMS).
Eight original participants in the EMS’s exchange rate mechanism began operating a formal network of mutually pegged exchange rates in March 1979.
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17. How the European Single Currency Evolved
Capital controls and frequent realignments were essential ingredients in maintaining the system until the mid-1980s.
After the mid-1980s, these controls were abolished as part of the EU’s wider “1992” program of market unification.
During the currency crisis that broke out in September 1992, Britain and Italy allowed their currencies to float.
In August 1993 most EMS currency bands were widened to ± 15% in the face of continuing speculative attacks.
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18. How the European Single Currency Evolved
German Monetary Dominance and the Credibility Theory of the EMS
Germany has low inflation and an independent central bank.
It also has the reputation for tough anti-inflation policies.
Credibility theory of the EMS
By fixing their currencies to the DM, the other EMS countries in effect imported the German Bundesbank’s credibility as an inflation fighter.
Inflation rates in EMS countries tended to converge around Germany’s generally low inflation rate.
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19. How the European Single Currency Evolved
Figure 20-2: Inflation Convergence for Six Original EMS Members, 1978–2006
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20. How the European Single Currency Evolved
The EU “1992” Initiative
The EU countries have tried to achieve greater internal economic unity by:
Fixing mutual exchange rates
Direct measures to encourage the free flow of goods, services, and factors of production
The process of market unification began when the original EU members formed their customs union in 1957.
The Single European Act of 1986 provided for a free movement of people, goods, services, and capital and established many new policies.
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21. How the European Single Currency Evolved
European Economic and Monetary Union
In 1989, the Delors report laid the foundations for the single currency, the euro.
Economic and monetary union (EMU)
A European Union in which national currencies are replaced by a single EU currency managed by a sole central bank that operates on behalf of all EU members.
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22. How the European Single Currency Evolved
Three stages of the Delors plan:
All EU members were to join the EMS exchange rate mechanism (ERM)
Exchange rate margins were to be narrowed and certain macroeconomic policy decisions placed under more centralized EU control
Replacement of national currencies by a single European currency and vesting all monetary policy decisions in a ESCB
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23. How the European Single Currency Evolved
Maastricht Treaty (1991)
It set out a blueprint for the transition process from the EMS fixed exchange rate system to EMU.
It specified a set of macroeconomic convergence criteria that EU countries need to satisfy for admission to EMU.
It included steps toward harmonizing social policy within the EU and toward centralizing foreign and defense policy decision.
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24. How the European Single Currency Evolved
EU countries moved away from the EMS and toward the single shared currency for four reasons:
Greater degree of European market integration
Same opportunity as Germany to participate in system-wide monetary decisions
Complete freedom of capital movements
Political stability of Europe
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25. The Euro and Economic Policy in the Euro Zone
The Maastricht Convergence Criteria and the Stability and Growth Pact
The Maastricht Treaty specifies that EU member countries must satisfy several convergence criteria:
Price stability
Maximum inflation rate 1.5% above the average of the three EU member states with lowest inflation
Exchange rate stability
Stable exchange rate within the ERM without devaluing on its own initiative
Budget discipline
Maximum public-sector budget deficit 3% of the country’s GDP
Maximum public debt 60% of the country’s GDP
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26. Euro Fixing Rates Copyright © 2009 Pearson Education, Inc.
17 Member States of the European Union use the euro as their currency
Belgium , Germany, Estonia, Ireland , Greece , Spain, France, Italy, Cyprus, Luxembourg, Malta, The Netherlands, Austria, Portugal, Slovenia, Slovakia, Finland
Non-participants
Bulgaria, Czech Republic, Denmark, Latvia, Lithuania, Hungary, Poland, Romania, Sweden and the United Kingdom are EU Member States but do not currently use the single European currency.
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27. The Euro and Economic Policy in the Euro Zone
A Stability and Growth Pact (SGP) in 1997 set up:
The medium-term budgetary objective of positions close to balance or in surplus
A timetable for the imposition of financial penalties on countries that fail to correct situations of “excessive” deficits and debt promptly enough
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28. The Euro and Economic Policy in the Euro Zone
The European System of Central Banks
It consists of the European Central Bank in Frankfurt plus 27 national central banks.
It conducts monetary policy for the euro zone.
It is dependent on politicians in two respects:
The ESCB’s members are political appointments.
The Maastricht Treaty leaves exchange rate policy for the euro zone ultimately in the hands of the political authorities.
The Eurosystem
Members
The legal texts which established the European System of Central Banks (ESCB) - the Maastricht Treaty and the Statute of the ESCB of were written on the assumption that all EU Member States will adopt the euro and that therefore the ESCB will conduct all the tasks involved in the single currency. However, until all EU countries have introduced the euro, it is the "Eurosystem" which is the key actor. The term "Eurosystem" covers the ECB and the national central banks of those EU Member States that have adopted the euro. Until now an unofficial term, it is mentioned for the first time in the Lisbon Treaty (Article 282 of the Treaty on the Functioning of the European Union).
The Eurosystem as the central banking system of the euro area comprises:
the ECB; and
the national central banks (NCBs) of the 17 EU Member States whose common currency is the euro.
The Eurosystem is thus a sub-set of the ESCB. Since the ECB's policy decisions, such as on monetary policy, naturally apply only to the euro area countries, it is in reality the Eurosystem, which, as a team, carries out the central bank functions for the euro area. In doing so, the ECB and the NCBs jointly contribute to attaining the common goals of the Eurosystem.
Why a system instead of a single central bank?
There are three main reasons for having a system of central banking in Europe:
The Eurosystem approach builds on the existing competencies of the NCBs, their institutional set-up, infrastructure, expertise and excellent operational capabilities. Moreover, several central banks perform additional tasks beside those of the Eurosystem.
Given the geographically large euro area and the long-established relationships between the national banking communities and their NCB, it was deemed appropriate to give the credit institutions an access point to central banking in each participating Member State.
Given the multitude of nations, languages and cultures in the euro area, the NCBs (instead of a supranational one) were best located to serve as access points of the Eurosystem.
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31. The Euro and Economic Policy in the Euro Zone
The Revised Exchange Rate Mechanism (ERM2)
It defines broad exchange rate zones for EU countries that are not yet members of EMU against the euro.
It specifies reciprocal intervention arrangements to support these target zones.
It is referred to as ERM 2.
It was viewed necessary in order to:
Discourage competitive devaluations against the euro by EU members outside the euro zone
Give would-be EMU entrants a way of satisfying the exchange rate stability convergence criterion
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32. The Theory of Optimum Currency Areas
It predicts that fixed exchange rates are most appropriate for areas closely integrated through international trade and factor movements.
The European monetary integration process has helped advance the political goals of its founders by giving the EU a stronger position in international affairs.
However the survival and future development of the European monetary union is heavily dependent on its ability to help countries reach their economic goals.
Here the picture is less clear because a country’s decision to fix its exchange rate can in principle lead to economic sacrifices as well as to benefits.
A country’s costs and benefits from joining a fixed exchange rate area such as the EMS depend on how integrated its economy is with those if its potential partners.
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33. The Theory of Optimum Currency Areas
Economic Integration and the Benefits of a Fixed Exchange Rate Area: GG Schedule
Monetary efficiency gain
The joiner’s saving from avoiding the uncertainty, confusion, calculation and transaction costs that arise when exchange rates float.
It is higher, the higher the degree of economic integration between the joining country and the fixed exchange rate area.
GG schedule
It shows how the potential gain of a country from joining the a currency area depends on its trading link with that region.
It slopes upward.
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34. The Theory of Optimum Currency Areas
Figure 20-3: The GG Schedule GG
Degree of economic integration between the joining country and the exchange rate area
Monetary efficiency
gain for the joining country
GG schedule shows how the potential gain to Norway from joining the euro zone depends on its trading links with that region.
We assume Norway is considering pegging its currency, the krone, to the euro
The upward sloping GG schedule shows that a country’s monetary efficiency gain from joining a fixed exchange rate area rises as the country’s economic integration with the area rises.
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35. The Theory of Optimum Currency Areas
Economic Integration and the Costs of a Fixed Exchange Rate Area: The LL Schedule
Economic stability loss
The economic stability loss that arises because a country that joins an exchange rate area gives up its ability to use the exchange rate and monetary policy for the purpose of stabilizing output and employment.
It is lower, the higher the degree of economic integration between a country and the fixed exchange rate area that it joins.
LL schedule
It shows the relationship of the country’s economic stability loss from joining.
It slopes downward.
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36. The Theory of Optimum Currency Areas
Figure 20-4: The LL Schedule
Degree of economic integration between the joining country and the exchange rate area
Economic stability
loss for the joining country LL
The downward sloping LL schedule shows that a country’s economic stability loss from joining a fixed exchange rate area falls as the country's economic integration with the area rises
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37. The Theory of Optimum Currency Areas
The Decision to Join a Currency Area: Putting the GG and LL Schedules Together
The intersection of GG and LL
Determines a critical level of economic integration between a fixed exchange rate area and a country
Shows how a country should decide whether to fix its currency’s exchange rate against the euro
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38. The Theory of Optimum Currency Areas
Figure 20-5: Deciding When to Peg the Exchange Rate
Degree of economic integration
between the joining country and
the exchange rate area
Gains and losses
for the joining country GG LL 1 1
Losses exceed
gains
Gains exceed
losses
The intersection of GG and LL at point 1 determines a critical level of economic integration , 1,between a fixed exchange rate area and a country considering whether to join.
At any level of integration above 1, the decision to join yields positive net economic benefits to the joining country.
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39. The Theory of Optimum Currency Areas
The GG-LL framework can be used to examine how changes in a country’s economic environment affect its willingness to peg its currency to an outside currency area.
Figure 20-6 illustrates an increase in the size and frequency of sudden shifts in the demand for the country’s exports.
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40. The Theory of Optimum Currency Areas
Figure 20-6: An Increase in Output Market Variability
Degree of economic integration
between the joining country and
the exchange rate area
Gains and losses
for the joining country GG
LL2
LL1 2 2 1 1
A rise in the size and frequency of country-specific disturbances to the joining country’s product markets, shifts the LL schedule from LL1 to LL2 because for a given level of economic integration with the fixed exchange rate area, the country’s economic stability loss from pegging its exchange rates rises. The shift in LL raises the critical level of economic integration at which the exchange rate area is joined to 2
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41. The Theory of Optimum Currency Areas
What Is an Optimum Currency Area?
It is a region where it is best (optimal) to have a single currency.
Optimality depends on degree of economic integration:
Trade in goods and services
Factor mobility
A fixed exchange rate area will best serve the economic interests of each of its members if the degree of output and factor trade among them is high.
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42. Is the EU an Optimum Currency Area?
If the EU/EMS/economic and monetary union can be expected to benefit members, we expect that its members have a high degree of economic integration:
large trade volumes as a fraction of GDP
a large amount of foreign financial investment and foreign direct investment relative to total investment
a large amount of migration across borders as a fraction of total labor force
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43. Is the EU an Optimum Currency Area? (cont.)
Europe is not an optimum currency area:
Most EU countries export form 10% to 20% of their output to other EU countries.
EU-U.S. trade is only 2% of U.S. GNP.
Labor is much more mobile within the U.S. than within Europe.
Federal transfers and changes in federal tax payments provide a much bigger cushion for region-specific shocks in the U.S. than do EU revenues and expenditures.
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44. Fig. 20-7: Intra-EU Trade as a Percent of EU GDP
Source: OECD Statistical Yearbook and Eurostat.
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45. Is the EU an Optimum Currency Area? (cont.)
Deviations from the law of one price also occur in many EU markets.
If EU markets were greatly integrated, then the (currency adjusted) prices of goods and services should be nearly the same across markets.
The price of the same BMW car varies 29.5% between British and Dutch markets.
How much does price discrimination occur?
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46. Is the EU an Optimum Currency Area? (cont.)
There is also little evidence that regional migration is extensive in the EU.
Europe has many languages and cultures, which hinder migration and labor mobility.
Unions and regulations also impede labor movements between industries and countries.
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47. Table 20-2: People Changing Region of Residence in the 1990s (percent of total population)
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48. Is the EU an Optimum Currency Area? (cont.)
Evidence also shows that differences of US regional unemployment rates are smaller and less persistent than differences of national unemployment rates in the EU, indicating a lack of EU labor mobility.
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49. Is the EU an Optimum Currency Area? (cont.)
There is evidence that financial assets were able to move more freely within the EU after 1992 and 1999.
But capital mobility without labor mobility can make the economic stability loss greater.
After a reduction of aggregate demand in a particular EU country, financial assets could be easily transferred elsewhere while labor is stuck.
The loss of financial assets could further reduce production and employment.
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50. Other Considerations for an EMU
The structure of the economies in the EU’s economic and monetary union is important for determining how members respond to aggregate demand shocks.
The economies of EU members are similar in the sense that there is a high volume of intra-industry trade relative to the total volume.
They are different in the sense that Northern European countries have high levels of physical capital per worker and more skilled labor, compared with Southern European countries.
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51. Other Considerations for an EMU (cont.)
How an EU member responds to aggregate demand shocks may depend on the structure of its economy compared to that of fellow EU members.
For example, the effects of a reduction in aggregate demand on the software industry will depend if a EU member has a large number of workers skilled in programming relative to fellow EU members.
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52. Other Considerations for an EMU (cont.)
The amount of transfers among the EU members may also affect how EU economies respond to aggregate demand shocks.
Fiscal payments between countries in the EU’s federal system, or fiscal federalism, may help offset the economic stability loss from joining an economic and monetary union.
But relative to inter-regional transfers in the U.S., little fiscal federalism occurs among EU members.
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53. The Theory of Optimum Currency Areas
Figure 20-9: Divergent Inflation in the Euro Zone
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54. The Future of EMU
If EMU succeeds it will promote European political as well as economic integration.
If EMU fails the goal of European political unification will be set back.
Problems that the EMU will face in the coming years:
Europe is not an optimum currency area.
Economic union is so far in front of political union.
EU labor markets are very rigid.
SGP constrains fiscal policies.
Sovereign Debt crises
Greece, Ireland, Portugal???
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55. Summary
The EMS was first a system of fixed exchange rates but later developed into a more extensive coordination of economic and monetary policies: an economic and monetary union.
The Single European Act of 1986 recommended that EU members remove barriers to trade, capital flows and immigration by the end of 1992.
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56. Summary (cont.)
The Maastricht Treaty outlined 3 requirements for the EMS to become an economic and monetary union.
It also standardized many regulations and gave the EU institutions more control over defense policies.
It also set up penalties for spendthrift EMU members.
A new exchange rate mechanism was defined in 1999 vis-à-vis the euro, when the euro came into existence.
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57. Summary (cont.)
An optimum currency area is a union of countries with a high degree of economic integration among goods & services, financial asset and labor markets.
It is an area where the monetary efficiency gain of joining a fixed exchange rate system is at least as large as the economic stability loss.
The EU does not have a large degree of labor mobility due to differences in culture and due to unionization and regulation.
It is doubtful if the EU could be classified as an optimum currency area.
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