1. Economics of Monetary Union 11e
Paul De Grauwe
Economics of Monetary Union 11e
Chapter 5: The Fragility of Incomplete Monetary Unions

2. Introduction
In previous chapters we made a distinction between complete and incomplete monetary unions
Complete monetary union: a monetary union together with budgetary union
Incomplete monetary union: a monetary union where each member country maintains its own independent budgetary policy.
We argued that an incomplete monetary union is fragile, and may in the end not be sustainable.
In this chapter we analyze the fragility of incomplete monetary unions more formally

3. Many gradations of incompleteness
Eurozone is one type of incomplete monetary union.
In the real world, there exist many monetary arrangements between nations that are far removed from the Eurozone-type of incomplete monetary union, and yet also follow rules, and constrain the national monetary policies of the participants.
One such arrangement is a fixed exchange rate system.

4. Fixed exchange rate regime as Incomplete monetary union
Fixed exchange rate regime is arrangement whereby the monetary authorities peg their exchange rates.
Examples: the Bretton Woods system and the ERM.
Over time most of these arrangements tend to disintegrate after some crisis:
the Bretton Woods system collapsed in 1973
the exchange rate mechanism (ERM) of the EMS collapsed in 1993
the South-East Asian currencies were hit by speculative attacks in
similar crises involved Latin American currencies in the 1990s.

5. Why are pegged exchange rate regimes so fragile?
The fragility of a fixed exchange rate system arises for two reasons:
There is a credibility problem
And a liquidity problem

6. Credibility problem
When the authorities announce a fixed exchange rate they are making a promise to keep the exchange rate fixed today and in the future.
The problem with any promise is that doubts may arise as to whether it will be kept.

7. Circumstances may arise in which the fixed exchange rate arrangement ceases to be seen as consistent with the economic welfare of the country.
In that case, the monetary authority will have an incentive to renege on its promise.
Economic agents will suspect this and will attack the currency.
A speculative crisis arises.

8. Liquidity problem
Countries on a fixed exchange rate have a limited stock of international reserves to defend the fixed rate.
The promise to convert domestic currency into foreign currency at fixed exchange rate cannot be guaranteed because central bank has insufficient amount of foreign exchange.
As investors know this, they will “become nervous” when they see that the stock of international reserves gets depleted.

9. Credibility and liquidity problems interact with each other:
the limited stock of international reserves reduces the credibility,
and low credibility leads speculators to sell the domestic currency,
forcing the central bank to sell foreign exchange, thereby depleting the stock of international reserves.

10. Simple model We assume country on fixed exchange rate
experiencing a current account shock: a sudden increase in current account deficit
This leads to increase in foreign debt
If current account deficit is not corrected foreign debt becomes unsustainable and country will default.

11. Country can solve this problem in two ways
Expenditure reducing policies (less spending more taxation)
But this is politically costly
Devaluing the currency
We assume this is politically less costly

12. Costs and benefits of devaluation: first generation model

13. Second generation model: multiple equilibria

14. BU-curve : benefit of devaluation when devaluation is not expected
BE-curve : benefit of devaluation when devaluation is expected (=speculative attack)
BE > BU because when devaluation is expected the defence of the fixed rate is very costly (central bank has to raise interest rate with negative effect on economy)

15. Three shocks a small shock: ε < ε1 ;
no devaluation because the cost exceeds the benefits
Speculators know this
They do not expect devaluation
Expectations consistent with outcome of model
Fixed exchange rate credible

16. large shock ε > ε2 devaluation is certain
because the benefits exceed the cost.
the fixed exchange rate is not credible
expectations are model consistent

17. intermediate shock: ε1<ε < ε2.
Two possible equilibria, N and D
In N: speculators do not expect devaluation; as a result cost > benefit; no devaluation occurs
In D: speculators expect devaluation; as a result cost < benefit; devaluation occurs
The selection of these two equilibria only depends on state of expectations
Self-fulfilling prophecy: It is sufficient to expect a devaluation for this devaluation to occur.

18. Important note
The existence of two equilibria ultimately depends on the fact that the central bank has a limited stock of international reserves.
Suppose the central bank had an unlimited stock of international reserves.
In that case, when a speculative attack occurs (speculators expect a devaluation), the central bank would always be able to counter the speculators by selling an unlimited amount of foreign exchange.

19. The central bank would always beat the speculators.
The latter would know this and would not start a speculative attack.
In other words they would not expect devaluation.
The BE curve would coincide with the BU- curve.
There would be no scope for multiple equilibria.

20. This does not mean that devaluations would not occur when authorities have infinite international reserves.
For shocks large enough, the authorities’ cost-benefit calculus would lead them to conclude that devaluing the currency would be better then not doing so.
As a result, they would devalue.
The point is that when the authorities have no international reserve constraint, they cannot be forced to devalue by the speculators.

21. A monetary union without a budgetary union
Fixed exchange rate regime is a particular type of incomplete monetary union.
The Eurozone is another type of incomplete monetary union.
The incompleteness arises because it is a monetary union without a budgetary union.
It will be seen that this leads to a similar fragility as the fixed exchange rate system.

22. In the Eurozone, there is one monetary authority (the ECB) and many independent national authorities that each control their own budget and issue their own debt.
The characteristic feature of this setup is that the national governments issue debt in the common currency.
This is a currency none of the national governments have direct control over.

23. Simple model of incomplete monetary union: the eurozone
Starting point is: there is a cost and a benefit of defaulting on the debt,
Investors take this calculus of the sovereign into account.
It is assumed that the country involved is subject to a shock, which takes the form of a decline in government revenues.
The latter may be caused by a recession, or a loss of competitiveness.
Call this a solvency shock.

24. Benefits of default
Figure 5.3 The benefits of default after a solvency shock.
benefits
Benefit of default:
Government reduces interest burden;
Cost of taxation reduced
Benefit increases with size of solvency shock
And size of govt debt
Solvency shock

25. Two benefit curves
Figure 5.4 Cost and benefits of default after a solvency shock.
BU = Benefit when default is not expected
BE = Benefit when default is expected

26. Cost and benefit of default
Figure 5.4 Cost and benefits of default after a solvency shock
Cost arises because of loss of reputation and thus difficulties to borrow in the future

27. Three types of shocks Figure 5.5 Good and bad equilibria
Small shock: S < S1
There will be no default because cost exceeds benefits,
Consistent with expectations
Large shock: S > S2.
Default is certain because benefits exceed costs
Intermediate shock:
S1 < S < S2
Two equilibria: N and D
Both consistent with expectations

28. When solvency shock is not too small nor too large:
One obtains two possible equilibria:
a bad one (D) that leads to default,
a good one (N ) that does not lead to default.
Both are equally possible.
The selection of one of these two points only depends on what investors expect.
If the latter expect a default, there will be one;
if they do not expect a default there will be none.
this remarkable result is due to the self-fulfilling nature of expectations.
We have coordination failure

29. The bad news about a bad equilibrium
Banking crisis
Automatic stabilizers switched off

30. Banking crisis
When investors pull out from domestic bond market, interest rate on government bonds increases, and prices plunge; domestic banks make large losses.
Domestic banks are caught up in a funding problem.
As argued earlier, domestic liquidity dries up (the money stock declines)
making it difficult for the domestic banks to rollover their deposits, except by paying prohibitive interest rates.
Thus the sovereign debt crisis spills over into a domestic banking crisis, even if the domestic banks were sound to start with.

31. Automatic stabilizers are switched off in MU
This dynamics makes it very difficult for members of monetary union to use automatic budget stabilizers.
A recession leads to higher government budget deficits.
This in turn leads to distrust of markets in the capacity of governments to service their future debt, triggering a liquidity and solvency crisis,
which in turn forces them to institute austerity programs in the midst of a recession.

32. In the stand-alone country (UK) this does not happen because the distrust generated by higher budget deficit triggers a stabilizing mechanism.
Member countries of a monetary union are downgraded to the status of emerging economies, which find it difficult if not impossible to use budgetary policies to stabilize the business cycle.
This feature has been shown to produce pronounced booms and busts in emerging economies (see Eichengreen, et al. (2005)).

33. Important note
As in the case of the fixed exchange rate regime, the existence of two equilibria is the result of the liquidity constraint faced by the national governments in the incomplete monetary union.
In order to see this, suppose that these governments would not face a liquidity constraint,
i.e. they could - like “stand-alone” countries - be sure that the central bank (in this case the European Central Bank) would always provide the liquidity to pay out the bondholders at maturity.

34. In that case, the government could always guarantee that the cash would be available.
Bondholders would not be able to force a default, if the government did not want to default.
The BE-curve would coincide with the BU-curve.
There would be no scope for multiple equilibria.
Put differently, a speculative selling of government bonds out of fear that the government may have insufficient cash would not be possible, if the government could guarantee that the cash would always be available.

35. Case study: From liquidity crises to forced austerity in the Eurozone
Two topics
Empirical evidence: strong increases in the government bond spreads in the Eurozone since 2010 :
were not only due to deteriorating fundamentals (e.g. government budget deficits and debt levels)
but were driven mainly by market sentiments (i.e. by panic and fear).
The ensuing spreads forced countries into severe austerity measures that in turn led to increasing government debt to GDP ratios.

36. Positive relation between Government debt and spreads
But sudden burst from 2010 that cannot be explained by increase in debt

37. Estimated from econometric equation linking spreads with whole series of fundamental variables
Time component is proxy for market sentiments (fear and panic)
Greece: mostly fundamentals’ driven; other countries: mostly market sentiments

38. How did the surge in the spreads that (as we showed) were mostly related to market sentiments affect the real economy?
This is the question of how these spreads and the ensuing liquidity problems forced the governments of these countries into austerity.

39. Figure 5.8 Austerity measures and spreads in 2011

40. Interpretation
Increasing spreads due to market panic, these increases gripped policy makers.
Panic in the financial markets led to panic in the world of policymakers in Europe.
As a result of this panic, rapid and intense austerity measures were imposed on countries experiencing these increases in spreads.
How well did this panic-induced austerity work?

41. Figure 5.9 Austerity (2011) and GDP growth (2011–12)

42. Figure 5.10 Austerity (2011) and increases in government debt–GDP ratios (2010IV–2012III).

43. Conclusion
In this chapter we have analyzed the inherent fragility of incomplete monetary unions.
We focused on two incomplete monetary unions,
i.e. a fixed exchange rate regime and
a Eurozone-type incomplete monetary union.
Both types of unions are characterized by a similar fragility.
In both cases, a lack of confidence can in a self-fulfilling way drive the country to a devaluation (in the first case) or to a default (in the second case.

44. Such fragility is problematic because it leads to questions of sustainability of incomplete monetary unions.
In the next chapter we discuss strategies aimed at making the Eurozone more sustainable