Current Issues in the Eurozone Cost benefits of membership in the euro area with some application (apply to experience

of some members). Discuss Portone 2004 January 1st 1999 put into circulation. EMU created in 1993 with Maastricht. o Job of the EMU to ensure price stability - annual inflation rate of less than 2 % result of that job was the euro. Move to a common currency for all EMU members had both positive and negative consequences. Clearly the benefits outweighed the costs, or the EMU would not have adopted the euro. Benefits Most important benefit - elimination of the need to exchange currencies between EMU members. o Members of the EMU were expected to save as much as $30 billion a year reduction in transaction costs associated with the exchange of currency by firms that import or export to or from many countries. problems with exchange rate volatility were also eliminated between members.

only left fluctuations between the euro, the dollar, the yen, and any other important national currencies from outside the EMU. Exchange rate fluctuations were another form of transaction cost, because they made trading between firms from different countries more risky. elimination of this risk will help international trade, therefore, giving advantages to all EMU countries. Two other major benefits of switching to the euro deal with the prevention of competitive devaluations and speculation. o A competitive devaluation is when one country devalues its currency in order to export more goods. In response, the trading partners of that country would do the same thing, resulting in a downward spiral regarding currency value, as well as an increase in inflation. goal of the EMU was to keep inflation rates low, the switch to a single currency made sense. o In terms of speculation, a single currency for the group of nations would eliminate speculation between member nations. Speculation occurred regularly throughout Europe because whenever people thought

that a currency was going to drop in value, they would sell all of their holdings in that type of currency. Others would follow. In order to control speculation European countries had to keep interest rates high. High interest rates hinder economies and that was the result in Europe for a large part of the early nineties. By eliminating speculation, the economies of member countries would be allowed to grow much more easily than when unnaturally high interest rates were necessary to ward off speculation. Cutting out speculation and the risk of competitive devaluation, as well as the need to convert from one currency to another, are all benefits that the European Monetary Union counted on when switching to a single currency. Costs each member nation relinquished its right to change monetary and economic policies in order to respond to economic problems at home exchange rates between countries were no longer adjusted by the individual countries to help regional economic slumps get moving. Major costs, however

o when looked at closely the idea of giving up individual monetary policy is not a big step for most of the European Monetary Union countries. o Since the creation of the EMU most member nations have already removed all trade barriers, making it easy to buy and sell goods across national borders. It has also made it very easy to lend and borrow, which means that EMU countries are already tied together in a semiunitary monetary policy. Main problem - one country can be in recession, and have no choice but to wait it out. o changing the monetary policy of the whole EMU for this country would hurt more countries then it would help. o The theory is that by creating a single currency economy throughout Europe, the economies will be tied together, and the business cycles will slowly come together. o If the business cycles of all the countries were in sync, then there would be no fear of one country being in a recession, while the others were economically stable Other ways of dealing with economic problems in individual countries. o Even though a country gives up its right to change monetary policy, it still retains the right

to change its fiscal policies before SGP and Fiscal Compact. o EMU countries will still be able to change how much they tax the people. o If only one EMU country is having economic problems, then the other countries can raise taxes in order to increase the purchasing power from those countries. Laffer Curve when you increase the tax ( no all tax just the tax know as the top income tax which aimed at the rich) that means the med income are not affected and they will have more money that will increase production and thus increase purchasing power). - Firas This doesnt really happen, votes etc. o Extra money can then be used to help bail out the country that is having problems. Other cost - labor-market reforms had to be made in order to avoid downward wage spirals. o changes in wage rates were the second of two ways that individual countries are still able to change fiscal policy. o Ordinarily, wages are not prone to move downward. o Stipulations were needed for people to make the possibility of wage cuts available to the governments.

o In the case of the EMU the stipulation was that the EMU governments had few other ways to control the economy. If workers were not willing to take a wage cut, then many could end up out of the job, because the economy would go bad if the government did not have control of the economy. o No clear outline for the labor-market reforms one of the main ideas was to increase the ease of labour mobility. firms need to make it easier for workers from other countries to work outside of their home country. The inability of workers to move from one country to another is mostly based on language barriers, so that was the first issue that needed to be looked at. Measures taken by the EMU to prevent the problems showed that they were prepared to stick with the euro. o led other countries from around Europe to apply for entrance into the EMU. o The idea that more countries were willing to join the system shows that there was not too much fear of the downsides. o If countries from outside the EMU are not shying away from joining, that meant that there was

probably not much uncertainty on the inside either. The positives and negatives of the common currency of the EMU are clear. EMU obviously thought positives out-weighed the negatives. o there was a positive attitude about the euro. o A positive attitude about any currency is one of the most important factors to its success. o Any time that people have lost confidence in a currency, either a major recession ensued, the currency succumbed to extreme inflation, or in some cases hyperinflation. Confidence in the euro bodes well for its success in the future. How has this affected countries? The biggest trouble with the Euro is the inability to adjust exchange and interest rates in order to counter assymetric shocks. Germany saw a rise in trade surpluses and competitiveness against other euro area members between 2002-2007 peripheral countries like Spain, Italy and Portugal have fallen behind accumulating large current account deficits as low productivity and high wages increased. With Greece the case was always bad fiscal discipline, both before and after the Euro, which led to the recession they are in now. Their only

sustainable options are imposing austerity measures coupled with growth and wage adjustments, while tightening internal fiscal discipline. Greece has made its bed and is now lying in it, unable to get itself back on top quickly due to regulations, especially as it should never have joined the in the first place. has certainly helped the northern countries, perhaps too much in hindsight. They ought to look at using their competitiveness (macroeconomic surplus) to counter a loss of competitiveness is countries like Italy, Greece and Portugal (i.e financing liquidity to counter macroeconomic deficits) Spain and Ireland especially always had a foothold in competitiveness With Ireland it was hard to converge its economy due to how quickly it was growing, among other reasons. At one point inflation was as high as 7%, with house prices rising rapidly. The result of handing over control of the money decisions to the European Central Bank was that Ireland went through a period of inflation and normal monetary restraints weren't available to policy makers. Difficult to find compromise. This week, Germany resisted calls to allow the direct recapitalisation in

Spanish banks, in order to save cash-strapped Spanish government from doing it themselves with what little they have. Spain is pushing for greater fiscal integration in Europe. Germany contributed to the increase in divergences in imbalances, hence it may contribute to reduce them through programmes of fiscal expansion and/or high wage growth. Stronger wage growth may have a detrimental effect on Germany by lowering its competitiveness. Portugal has a greater debt than Greece, with a fast shrinking economy. It is also suffering from dangerously high interest rates on bond yields (above 10% for almost a year) Countries on the other hand have experienced a boost in foreign investment thanks to what the Eurozone offers, coupled with the numerous advantages of the single market After adoption of the Euro, some countries experienced a temporary loss of growth in order to fulfill the inflation criterion. First members of EMU had quite similar economies, later economies suffered because of the one sized fits all policy. As these were very different, different

rates of growth, policies etc, these reflected also on their current balances. (OCA) requires that member countries are to be homogenous and integrated as much as possible because a one-size-fits-all policy within a monetary union would not be able to cater the best circumstances for all of its members Optimum Currency Area (Mundell) In establishing the Single Currency a number of economic fundamentals were ignored A group of countries would benefit most by using a common currency if a number of basic conditions are satisfied The extent and volume of trade: Countries that are highly integrated with each other, with respect to international trade in goods and services, are more likely to constitute an OCA [...] since greater trade leads to greater savings in the transaction costs and risks associated with different currencies. Frankel and Rose (1998) Similarity of shocks and cycles: members of the area should not be subject to asymmetric shocks. The more highly correlated business cycles are across the member countries, the more optimal is the common currency

Factor (especially labour) mobility: countries with good opportunities should attract factors of production, including labour, from those with fewer employment opportunities. Fiscal Harmonisation: For a currency area to operate optimally there should be a harmonised fiscal policy a central fiscal authority should also be able to redistribute income across the different member states as required. EMU Monetary and Fiscal criteria established for countries to join the Euro are not the same as the OCA criteria established by Mundell. Monetary Convergence: Inflation stability Long-term Interest Rate stability Exchange Rate: must have remained within the normal bands of the existing ERM II system of exchange rates, "without severe tensions" for a continuous period of at least two years. Fiscal Convergence Criteria, the general government deficit: must be below 3% of GDP and

public debt: below or trending towards 60% of GDP. The euro area has performed better since the creation of the single currency than before While economic growth has been around 2% since the creation of the single currency, similar to its prior level, employment growth has been strong, fiscal performance has improved and real interest and inflation rates have fallen. The euro very quickly established its role in foreign exchange and international security markets and has become an important reserve currency. Is the EU an OCA? Similarity of Shocks and Cycles Similarity of Shocks and Cycles Since monetary policy is now a one size fits all policy, if cycles are not correlated, the policy will be too loose for the booming economies and too tight for the poorer ones Major difference lies between the Northern more industrial-based countries and Central Eastern European Countries and the Southern Mediterranean countries

Smaller core of EU countries comprised of Germany, France, Belgium, Netherlands, and Denmark form a more homogeneous group, and therefore more qualify as an OCA. Closer trade links and an increase in the volume of trade results in more closely correlated business cycles Commission claims that business cycles have become more synchronised between participating countries during the decade preceding the creation of the single currency Further integration leads to more diversification; hence, closer trade ties could result in countries becoming more specialised in sectors in which they have a comparative advantage. asymmetric shocks tend to be more common at the levels of regions within a country than at the level of nations within Europe. De Grauwe Euro moving further away from being an OCA Factor Mobility Factor (especially Labour) Mobility Low Labour Mobility in the EU due to various barriers. Language, qualifications.

Labour mobility is greater in the US than in the EU o Various economists believe that labour markets rigidity is one of the main causes of high unemployment in the EU, especially the Euro Area. Fiscal Harmonisation o A single monetary policy (or rather an OCA) requires a single or common fiscal policy, because if one or several members increase their spending and debt disproportionably, they produce negative externalities on the others, who tend to buy their debt without exchange-rate risk. o US federal budget acts as a powerful stabiliser, enabling fiscal transfers to automatically flow from booming to slumping states o Ireland suffered mostly from loose banking regulation, Italy suffered from low economic growth and Greece from fiscal imprudence Conclusion Alternative mechanisms of adjustment in the euro area were deemed to be comparatively weak. Low labour mobility within and across borders, weak responsiveness of prices and wages to the business cycle, and the limited degree of integration of

financial markets along with the absence of crossborder fiscal transfers Inadequate fiscal redistribution and Member States limited labour mobility, a major asymmetric shock would collapse the entire euro area

ECB and monetary policy and the challenges Intro o Delors Committee Report identified the need to vest the responsibility for the single monetary policy in a new institution o centralised and collective decisions would be taken on the supply of money and credit as well as other instruments of monetary policy. o EMU introduced during the second stage of the economic and monetary union, laid the grounds and acted as a precursor for what was to become the European Central Bank o Established on 1 June 1998, the ECB is a supranational institution with its own legal personality. The central bank for EMUs single currency Responsibility for framing and implementing the EUs economic and monetary policy

o Not easy as ECB had to create a new currency and policy by bringing together different national economic and political systems without causing reasons for panic in financial markets. o Had to prove that the institution was capable of managing domestic and international aspects of the Euroareas monetary affairs successfully European System of Central Banks ECB & national central banks (NCB) of 27 EU member states Eurosystem ECB & 17 NCBs of member states which adopted the Euro Institutional design Governing Council o Most important decision making body o Formulates policy and adopts guideline o Plays a crucial role in the administration and functioning of the ECB o Members : Executive Board + 17 NCB governors o Acts by simple majority members do not represent member states o Meets twice a month o Meetings are followed by a press conference; refuse to publish minutes

Institutional design Executive Board o Implements monetary policy and gives instructions to national central banks (NCBs) o Sets the agenda for the meeting of the Governing Council o The power of the Executive Board within the sphere of influence o Appointed members: the President, the VicePresident and four other members o Strong sentiment on collective status of the economy of the EMU o Still influenced by the desires of the larger countries Institutional design General Council o Members: President and Vice-President of ECB + NCB governors of 27 member states o Other members may be present but do not have a right to vote o Regarded as a transitional body o Contributes to advisory function of the ECB, collects statistical information o No role in the formulation of monetary policy of the Eurosystem o Has a supervisory and co-ordinating function for member states adopting the euro

Objectives of ECB According to Treaty - high level of employment and sustainable non-inflationary growth. o Though considered important, such goals are second in priority, after price developments. In the long-run growth and unemployment do not depend on monetary policy, but on structural factors of the economy price stability is the most important contribution that monetary policy can make to achieve sound macroeconomic management and a high level of employment. Maintain price stability o using the rate of change of harmonized index of consumer prices (HICP) below but close to 2% as a benchmark over the medium term. This is a benchmark, there is no explicit target. o safeguarding the value of the euro o Increased price transparency o valuable contribution to a favourable macro economic environment and employment. Investors given guarantee that there wont be price hikes in the future. o price stability helps to maintain social cohesion, stability and prevents arbitrary redistribution of

wealth. Ultimately, it also contributes to financial stability. Support the general economic policies of the Union maintenance of high employment & sustainable noninflationary growth, provided they do not hamper the attainment of the objective of price stability German Model The German model vs. the Anglo-French model o German based on the objective a central bank should pursue, such as price stability ensures that the central bank is politically independent and no political authority or any other institution may revoke or even try to influence a decision taken by the central bank o Anglo-French based on the institutional design having other objectives such as employment, stabilization of business cycles, aside from price stability - much less independence and the central bank to a certain extent, remains under the scrutiny of the government The ECB was modeled on the German model. Price stability remains primary objective and is completely independent. De Grauwe identifies two main reasons why the German model prevailed o development of the monetarist paradigm

o influential if not leading role of Germany in the process towards EMU. In view of the size of Germanys economy it was nearly natural that Germany would take a leading role in negotiating and determining the parameters of the EMU. Germany was very fearful that when it joined the EMU this was going to impact negatively its stance on inflation. As a result, their participation was made conditional to the notion that the ECB puts greater emphasis on price stability more than the Bundesbank did. In other words, this meant Europeanizing the German model of economic stability. Eurosystem ECB + NCBs which have adopted the euro Carries the central bank functions for the euro area which jointly contribute to attain the common goals of the Eurosystem Will continue to co-exist with ESCB until all member states adopt the euro Centralised decision-making, decentralised operations Basic principle - having a centralized decisionmaking system which then operates via decentralized operations o Network of communities

each national central bank and the ECB has a member. Eurosystem carries out the central bank functions for the euro area. ECB and the national central banks jointly contribute to attaining the common goals of the Eurosystem. Basic tasks of the Eurosystem: o the definition and implementation of monetary policy for the euro area o the conduct of foreign exchange operations o the holding and management of the official foreign reserves of the euro area countries o the promotion of the smooth operation of payment systems o contributing to the smooth conduct of the policies of the authorities responsible for the prudential supervision of credit institutions. o Monetary policy two pillar strategy of the Eurosystem Quantitative reference value for growth comprehensive analysis of a wide range of other economic and financial variables o Basic tasks all point to maintaining price stability. Generally successful in 2011, governing council decided to raise interest rates to push inflation below 2%. o Overall aim - Safeguarding financial stability and promoting financial integration

o Establishing an integrated system while ensuring a prominent role for NCBs in implementing and formulating monetary policy . NCBs are subordinated to the ECB to allow the Eurosystem to operate efficiently as a single entity while also act as operative arms o The Eurosystem and its flaws De Grauwe - Eurosystem is not only concerned with monetary policy, but has a whole spectrum of activities, functions and interests. Institutional setup for ensuring financial stability is mostly a national affair, and following the crisis its ability to manage it has been seriously put to test. Central Banking and Assymetric Shocks o effectiveness of the ECB to respond and stabilise shocks, particularly when it comes to output and employment, is partially dependent on whether member states form an OCA. o If participating member states do not form part of an OCA, the ECB has a much more challenging task to rectify the effects of asymmetric shocks and realign the economies.

o when member states face asymmetric shocks it is unlikely that the ECB will intervene in interest rates to stabilize output and aggregate demand. o lack of intervention by the ECB either because the divergent situations paralyse its functions or else because it places little attention to output stabilization. o ECB has failed to raise interest rates immediately even in times of positive economic situations. o Often left with a choice between easing or tightening monetary conditions o Asymmetric shocks create a problem of when to react Policy conflicts arise o When the degree of asymmetries increases, the effectiveness of stabilization of output and employment are significantly reduced o The ECB has a limited role in responding to permanent shocks o ECB has shown a greater degree of flexibility in responding to asymmetric shocks when it introduced its two pillar monetary strategy. o Through its policies it may contribute in the long term to restore equilibrium o Temporary shocks combatted by interest rates & output gap o A positive asymmetric shock (boom in one member) cancels a negative asymmetric shock (recession in another member) lack of reaction from central bank

Conclusion o Successful in the maintenance of price stability o The lack of action to respond to asymmetric shocks o The need to look beyond price stability o The crisis has strengthened the ECB and made it more influential