Macroeconomic Policies
in the EU
Course given by Kiril Strahilov, PhD
at MGIMO, Russia
7-10 October 2006
Course Outline
1. European Macroeconomic Policies
1.1. Brief Revision of European Monetary Integration
1.2. Recent Macroeconomic Developments in the Euro Area
1.3. Macroeconomic Policy Settings
1.4. The External Dimension.
2. The Euro Area as an Optimum Currency Area (OCA)
2.1. Benefits of OCAs
2.2. Costs of OCAs
2.3. Costs and Benefits compared
3. Monetary and Fiscal Policies in the Euro Area. 9)
3.1. Institutional Aspects of the ECB: Credibility, Accountability and Independence.
3.2. The Transmission Mechanism of Monetary Policy
3.3.The Reform of the Stability and Growth Pact
4. The Euro Area Enlargement
The Road of the Ten new EU Members towards EMU
5. European Unemployment Basic Facts
5.1. The Initial Rise of Unemployment: the Role of Shocks
5.2. Continuing Unemployment: Sources of Persistence
5.3. High Unemployment: the Role of Institutions
2
Bibliography
• Blanchard, O. (2006). European Unemployment. Economic Policy
Journal, pp. 7-59.
• De Grauwe, Paul (2006). Economics of Monetary Union. 6th edition.
Oxford University Press, Oxford
• European Central Bank (2004). The Monetary Poly of the ECB. ECB,
Frankfurt.
• European Commission (2006). Annual Report on the Euro Area –
2006. Directorate General for Economic and Financial Affairs.
• Schadler, S. et al (2005). Adopting the Euro in Central and Eastern
Europe. Challenges of the Next Step in European Integration. IMF
Occasional Paper 234.
• Zestos, George K. (2006). European Monetary Integration. The Euro.
Thomson south-Western, London
3
1. European Macroeconomic
Policies
1.1. Brief Revision of European
Monetary Integration
Bretton Woods Regime
(fixed exchange rates)
• Stable exchange rates, but adjustable
–
–
–
–
US dollar fixed in terms of gold ($35 an ounce)
fixed parity for other currencies in terms of dollar
band around dollar parity: plus or minus 1.0 %
adjustment of parities after consultation with the
IMF
• adjustments discouraged, allowed in case of
serious balance of payments disequilibria,
postponed by IMF loans
– Central Banks of member countries hold reserves
in gold or dollars
– and have right to sell dollars for gold to Federal
Reserve
5
Bretton Woods Regime
(fixed exchange rates)
• Consequences
– dollar becomes the international currency
(international dollar standard or gold
exchange standard)
– dollar takes on role of reserve currency
(interest bearing)
– Central Banks must intervene in foreign
exchange markets to stabilise the
exchange rate of their currencies by buying
and selling dollars
6
Problems of B-W regime
• Problem 1: Nth Currency Problem
– two currencies means one exchange rate
• (N currencies mean N-1 independent exchange rates)
– both countries cannot independently fix the
exchange rate.
– EITHER both co-operate (symmetric solution)
– OR one follows a policy of “benign neglect”
(asymmetric solution). Role played by the USA
• Problem 2: Realignments
– definition: changing the exchange value of a
currency.
– rendered difficult by the rules of the regime
– postponed as much as possible.
– Result:
7
Problems of B-W regime
• Problem 3: Speculative attacks
– Exchange rate value loses credible
– Massive sales (normally) or purchases of the
currency.
• Breakdown of Bretton-Woods regime
– Inflation rises in the United States of America
• accelerates because of expansionary
monetary policies (Vietnam war)
fiscal
and
– Two effects
• Purchasing power value of US$ falls
• Other countries “import” American inflation. (see further)
– Markets start selling dollars in large quantities
– Movement started by request of the Banque de
France (de Gaulle) to USA to convert its dollar
holdings into gold (“exorbitant privilege”).
8
Problems of B-W regime
• Breakdown of Bretton-Woods regime (cont’d)
– August 15th 1971. Nixon closes “gold window”
– December 1971. Smithsonian Agreement: general
realignment and increase of band to plus or minus
2.25%
– March 1973: free floating
– Strong fluctuations of European currencies against
the dollar – and, therefore, even stronger
fluctuations between the European currencies
– 1976: Jamaica Agreements (official end to BrettonWoods period)
– In this context, the European Monetary System
(EMS) is born.
9
First Steps Towards European
Monetary Integration
• Establishment of the European Payments Union (EPU) with
effect from July 1950.
• Principal purpose of EPU: facilitate payments for trade in goods
between the OEEC member countries in a world where currency
convertibility was still an issue.
• The EPU was a clearing union that replaced the existing
agreements by a multilateral settlement and credit mechanism:
– bilateral claims and liabilities for each country were
consolidated on a monthly basis in a single net position
which defined the balance of payments situation of the
country vis-à-vis the rest of the EPU countries.
10
First Steps Towards European
Monetary Integration
• Settlements could occur by payment in gold or dollars, or by
automatic credit limited by quotas.
• EPU set up to allow OEEC countries to liberalise trade in goods
during the transition to currency convertibility.
• Eichengreen (1993): immediate introduction of currency
convertibility would have required large devaluations in addition
to the currency realignments of 1949 and a consequent
immediate loss in real income. Introduction of EPU avoided this,
and gave member countries the time to redeploy their
economies before rendering their currencies fully convertible.
Without the EPU, multilateral trade in goods would have been
endangered.
11
First Steps Towards European
Monetary Integration
• The Shuman Declaration of May, 9th 1950
• The Treaty of Paris signed in April 1951
established the European Coal and Steel
Community (ECSC)
• Common market for the two commodities,
eliminating tariffs and quotas between the
six member states
12
First Steps Towards European
Monetary Integration
• Messina Conference (Sicily) in June
1955 – possibility of establishing a
Customs Union was studied
• On March 25th 1957 two more treaties
were signed – European Economic
Community (EEC) and the European
Atomic Energy Community (EURATOM)
13
First Steps Towards European
Monetary Integration
• On 1 January 1958, the Treaty creating the European
Economic Community (EEC) took effect.
• Monetary matters were one of the least concerns in
the Treaty. Exchange rate policies came under the
jurisdiction of the International Monetary Fund (IMF).
• The Treaty did require that the Member States of the
newly formed EEC
follow economic policies which were compatible with
the Brettton-Woods commitments:
- currency convertibility,
- stable nominal exchange rates, and
- liberalisation of capital markets “to the extent
necessary to ensure the proper functioning of the
common market” (Article 67, EEC);
14
First Steps Towards European
Monetary Integration
• and with fundamental economic policy objectives
(balance of payments equilibrium, high level of
employment and a stable level of prices).
• The Treaty also required of the Council of Ministers of
the Member States that they ensure the coordination
of the general economic policies of the Member
States (Article 145).
• The general rules regarding economic and monetary
policies were laid down in Articles 104 to 109 and for
the liberalisation of capital movements in Articles 6773.
• A Monetary Committee was created with a purely
advisory role.
15
First Steps Towards European
Monetary Integration
• One event in this period is telling: the German revaluation
of 1961, but its lessons were not learnt when the
Maastricht revision of the Treaty was undertaken.
• Germany was subject to inflationary pressures both on
account of a high level of domestic demand and large
surpluses in the balance of payments current account.
• A restrictive monetary policy on its own would have led,
and did lead, to an increase in capital inflows and in
inflationary pressures.
• It also resulted in an excessive squeeze on domestic
demand.
• A revaluation of the currency was not encouraged by the
IMF nor by certain domestic authorities.
• The German central bank, the Bundesbank, did not have
the authority to revalue the currency which was a
competence of the Federal Government.
16
First Steps Towards European
Monetary Integration
• In the end, the Bundesbank was obliged to stop its
restrictive monetary policies,
• and a revaluation of the Deutsche Mark occurred.
• The conflict between internal and external balance
could have been avoided to a large extent
• if both monetary and exchange rate policies had
been under the same authority.
• But is this politically feasible?.
17
First Steps Towards European
Monetary Integration
• Meeting of Heads of State or Government of
the EEC at the Hague in December 1969
• Requests Council of Ministers to draw up a
plan by stages for creation of an economic
and monetary union.
– task proves difficult because of opposing
“economist” and “monetarist” views.
• “economists”: first a high degree of
convergence in economic fundamentals and
policies;
• “monetarists”: rapid introduction of a monetary 18
union followed by economic convergence
First Steps Towards European
Monetary Integration
• Creation of Werner Commission in March
1970 to address the issue.
• Werner Report (October 1970)
– complete liberalisation of capital flows
– monetary union = irrevocable fixing of exchange
rates
– community system of national central banks
– centralised economic policy
– to be achieved in 3 stages completed by 1980
• compromise between “economist view” and “monetarist
19
view”
First Steps Towards European
Monetary Integration
• Werner project endorsed by European Council in 1971 but...
was overtaken by events
• The Marjolin Committee declared the project dead in 1975
• The Snake (in the Tunnel)
– block floating between March 1973 and Dec. 1978
– tunnel between April 1972 and March 1973
– members change frequently and realign frequently
– snake lasts till 13 March 1979
upper intervention point (+2.25%) (sell $)
dollar parity
lower intervention point (- 2.25%) (buy $)
20
Creation of the European
Monetary System (EMS)
• 13 March 1979: EMS comes into existence
• Result of initiative taken by Roy Jenkins in Oct. 1997 and
followed up by Helmut Schmidt (German Chancellor) and
Valéry Giscard d’Estaing (French President)
• Based on a European Council Resolution dated
5 December 1978
• Main characteristics and operating procedures contained
in an Agreement Between [all] the Central Banks of the
Member States of the EEC.
• Defined a system of fixed but adjustable exchange rates
between participating countries.
21
How EMS addressed BrettonWoods Regime Problems
• Asymmetry
– introduction of ECU
• a basket of currencies of all Member States
• each currency in the basket assigned a
weight
–the weight could change over time
• replaced European Unit of Account
22
The ECU
A basket of all EC currencies
Belgian franc = Belgian (3.301) and Luxembourg (0.13) franc
23
How EMS addressed BrettonWoods Regime Problems
• Asymmetry (cont’d)
– introduction of an Exchange Rate Mechanism
• participation in ERM not obligatory
• each participating currency assigned a (bilateral)
central parity with respect to each of the other
participating currencies (defines a parity grid )
• maximum variation of 2.25% on either side of central
parity allowed
– Italy granted exception of 6% on either side.
24
How EMS addressed BrettonWoods Regime Problems
• Asymmetry (cont’d)
– obligatory and unlimited intervention at the margin
• suppose 1 DEM equalled 20 BEF (central parity)
• market exchange rate could vary between
19.55 and 20.45 BEF
• if market rate reached either bound, both the
Belgian National Bank and the German
Bundesbank had to intervene in the market
25
How EMS addressed BrettonWoods Regime Problems
• Asymmetry (cont’d)
– obligatory and unlimited intervention at the
margin (cont’d)
• if the exchange rate rose to 20.45 (appreciation of
mark and depreciation of franc)
• the Bundesbank and the Belgian National Bank
would have to sell marks and buy francs
• German Bundesbank at an advantage because it
could print as many marks as it needed
• Belgian National Bank at a disadvantage because it
had a limited stock of marks to sell.
• Why oblige both to intervene?
26
How EMS addressed BrettonWoods Regime Problems
• Asymmetry (cont’d)
– obligatory and unlimited intervention at
the margin (cont’d)
• because as a result of the intervention, the
German money supply increased and the
Belgian money supply decreased
• German interest rates fell and Belgian
interest rates rose, stabilising the exchange
rate
27
How ERM addressed BrettonWoods Regime Problems
• Realignment
– At the request of one or several countries participating
in the ERM, a consultation occurred involving the
Ministers of Finance and the Governors of the Central
Banks of all the participating countries.
– These decided whether and to what extent a
realignment should take place.
– Consequently, realignments were carried out rapidly
and with the agreement of the participating countries.
– The consultation often limited the extent of the
realignment out of fear of loss in competitiveness.
28
How ERM addressed BrettonWoods Regime Problems
• Speculative Attacks
– obligatory and unlimited interventions by the
two Central Banks whose currencies were
involved
– markets would then know that between them
the Central Banks would not run out a
currency
– this would reduce the probability of a
speculative attack
29
Functioning of ERM of EMS
• Four phases in the functioning of the ERM
– March 1979 to March 1983
• Participating countries going there own way
policy-wise.
7 realignments.
– April 1983 to January 1987
• Participating countries beginning to recognise
the constraints on policy imposed by the ERM.
4 realignments.
– February 1987 to September 1992
• The “hard” EMS. 1 “technical” realignment
(Italy).
– October 1992 to end 1998
• the period following the “breakdown” of the
EMS and preceding monetary union
30
Functioning of ERM of EMS
• Four phases in the functioning of the ERM
31
Functioning of ERM of EMS
Inflation
18
France
16
Germany
14
Italy
12
Netherlands
10
8
6
4
2
0
1950-1972
1973-1978
1979-1985
1986-1991
1992-1998
32
Functioning of ERM of EMS
• Why did the ERM “break down” in Sep. 1992?
– Remote causes
• the system had become too rigid
– markets convinced no more realignments
before monetary union (Delors effect)
• loss of competitiveness of certain countries
• large capital flows into high interest rate
countries (Italy, Spain and Portugal)
– is this compatible with interest rate parity?
– risk premium.
33
Functioning of ERM of EMS
• Why did the ERM “break down” in Sep. 1992?
– Remote causes (cont’d)
• the system had become asymmetric and
dependent on Germany
– the Bundesbank set the interest rate for
Germany
– the other ERM countries tied their
currencies to the German mark
– the other ERM countries adapted their
interest rate to Germany’s
» In the ERM, Germany played the role
that the USA played under BrettonWoods
34
Functioning of ERM of EMS
• Why did the ERM “break down” in Sep. 1992?
– Proximate causes:
• capital flows (liberalisation of capital flows in 1990)
• the Bundesbank hikes up its interest rate after reunification
• Maastricht Treaty vote in Denmark and in France
• Solution: either floating exchange rates or move to
monetary union
» Britain chose floating
» as did Italy and Spain temporarily
– fluctuation margins increased to 15% on both sides
of central parity
35
Functioning of ERM of EMS
• “Impossible or Incompatible Trinity”
– independent monetary policy
• that is, achieve an internal target
– fixed exchange rates
• that is, achieve an external target
– free movement of capital
One of these three goals must be given up.
36
Transition to a Monetary Union
• The Delors Report
• The Maastricht Treaty
– The 3 stages
– Stage Two: preparing for monetary union
• establishment of the European Monetary
Institute
• countries shall endeavour to avoid excessive
fiscal deficits
• the criteria for membership
– Stage Three: monetary union
37
Criteria for membership
1. The government deficit may not exceed 3% of
Gross Domestic Product at market prices.
If it does, the Commission must take into account
whether it has declined substantially
and continuously or
the excess is temporary in nature.
Furthermore, it must examine whether the deficit
exceeds expenditure on investments as well as
certain other elements
38
Criteria for membership (cont’d)
2. Government debt may not exceed 60% of
Gross Domestic Product.
If it does, the Commission should take into
account
- whether the ratio is diminishing
sufficiently and
- approaching the reference value at a
satisfactory speed.
39
Criteria for membership (cont’d)
3. The inflation rate is sustainable
and, over the year preceding examination,
does not exceed by more than 1.5%
that of, at most, the 3 best performing
Member States.
The consumer price index shall be used
40
Criteria for membership (cont’d)
4. Long term interest rates (on long-term
government bonds or comparable assets) shall not
exceed,
over the year preceding examination,
by more than 2%
that of, at most, the 3 best performing Member
States in terms of inflation rates.
41
Criteria for membership (cont’d)
5. The Member State
- shall have participated in the ERM of
the EMS and
- respected the normal fluctuation
margins without severe tensions
for at least two years before the
examination.
It shall not have devalued its currency against any
other Member State's currency on its own initiative for
the same period.
42
Criteria for membership (cont’d)
Some authors also add a legal convergence
criterion, i.e., the countries legislation should
conform to the Treaty in matters such as central
bank independence and the ESCB Statute.
43
Transition to Membership
• Public finances consolidation
– EMU as deflationary? or stock
adjustment?
• Exchange rate mechanism
• Real convergence
– not included in Maastricht Treaty criteria
– was not a problem for “old” Member States
– but may be one for new Member States
44
The Path of the Euro
45
1.2. Recent Macroeconomic
Developments in the Euro Area
1.2. Recent Macroeconomic
Developments in the Euro Area
• Following Relative mild downturn in 2001-2003,
the euro-area economy experienced a
comparatively slow recovery
• In 2006 economic growth is expected to
accelerate (EC Commission forecast – 2.6 %
increase in GDP for 2006) with countries like
Finland, Greece, Spain, Ireland and
Luxembourg growing more than 3 %.
47
1.2. Recent Macroeconomic
Developments in the Euro Area
• The euro-area’s economic recovery is
underpinned by a strengthening of domestic
demand, particularly investment
• Total Investment is expected to grow by 4.2 %
• This is due mainly to historically low interest
rates, improved corporate balance sheets
• The Outlook for consumption in the Euro Ares in
2006 is for a modest upturn – 1.7 % increase
48
1.2. Recent Macroeconomic
Developments in the Euro Area
49
1.2. Recent Macroeconomic
Developments in the Euro Area
• The euro-area’s economic recovery is also
being helped by the continued strong
expansion of world output and trade
• World GDP at 4.6 % (strong overall
performance in China, India, Japan and
USA)
• World trade growth in 2006 is expected to
be around 8% - with EU exportsto the rest
of the world growing by 5.5%
50
1.2. Recent Macroeconomic
Developments in the Euro Area
51
1.2. Recent Macroeconomic
Developments in the Euro Area
• The European Commission expects consumer
price inflation to remain at 2.1% in the euro area
in 2006
• Core inflation (CPI excluding energy and
unprocessed food) continued to decline and
stood at 1.5% in May 2006
• Oil prices have recently reached record high
levels of 70 USD per barrel of Brent crude oil.
• According to Commission estimates price per
barell in 2006 will average 68.9 USD (27.4%
increase compared to 2005). Effect on Euro area
CPI should be moderate (see box 1.1)
52
1.2. Recent Macroeconomic
Developments in the Euro Area
53
1.2. Recent Macroeconomic
Developments in the Euro Area
54
1.2. Recent Macroeconomic
Developments in the Euro Area
• Potential risks to continued investment
growth in the EU:
• Further increasing oil prices
• The impact of the budgetary consolidation
in Germany (increase of VAT from 16% to
19%) – German households may bring
forward some purchases of durable
consumer goods. Hence German GDP is
expected to fall slightly in 2007
55
1.3. Macroeconomic Policy
Settings
1.3. Macroeconomic Policy
Settings
• The overall aim of macroeconomic policy in the
euro area is to keep output close to potential,
whilst preserving price stability.
• In the medium term: minimization of uncertainty
of households and businesses about future
macroeconomic policies; stimulating
consumption and investment decisions
• The short term responsiveness of policies is
essential as economic circumstances change
continuously.
57
1.3. Macroeconomic Policy
Settings
• Monetary conditions: Monetary policy has
helped to spur economic activity and promote
confidence through historically low nominal and
real interest rates.
• Recent increases should help to anchor
medium- to long-term inflation expectations (see
graph 2.2)
• Interest rates are very low from historical
perspective – the lowest interest rate ever
attained by the German Bundesbank (BuBa)
was 2.5%
58
1.3. Macroeconomic Policy
Settings
59
1.3. Macroeconomic Policy
Settings
• Inflation rates have stayed close but above the
ceiling of 2 per cent.
• Long-term inflationary expectations are below 2
% (see graph 2.4).
• The euro-area’s economic recovery has
coincided with a remarkable degree of wage
moderation (due to the behavior of social
partners): Low wage growth can help to reduce
inflationary expectations.
• On the contrary – high inflationary expectations
lead to high inflation and may jeopardize the
economic recovery.
60
1.3. Macroeconomic Policy
Settings
61
1.3. Macroeconomic Policy
Settings
• Fiscal Policy: Fiscal policies remain the
responsibility of individual member states,
but there are some general requirements
set in the EC Treaty and in the SGP.
• Member states can make e positive
contribution to economic growth by
improving the quality if their public finance.
• The euro area is already burdened with
too high level of debt (see graph 2.8)
62
1.3. Macroeconomic Policy
Settings
63
1.3. Macroeconomic Policy
Settings
• Another reason to improve the sustainability of
public finances is the additional budgetary
pressure that will stem from the ageing of the
euro-area’s population (see graph 2.9).
• Change of the old-age dependency ratio
• Pressure on public finances
• Conclusions: EMU’s policy framework has
contributed to a very favourable macroeconomic
policy mix.
64
1.3. Macroeconomic Policy
Settings
65
1.4. The External Dimensions
1.4. The External Dimensions
• Since its launch in 1999, the euro has become
the second most important international
currency, behind the US Dollar.
• In the first half of 2006, the euro appreciated
against the US dollar and the Japanese Jen,
having depreciated in both cases in 2005 (see
graph 4.1)
• Interest rate differentials (see graph 4.3) and
global imbalances (see graph 4.4) will play a
role in determining whether there will be
continued appreciation of the euro or a further
dollar strength.
67
1.4. The External Dimensions
68
1.4. The External Dimensions
69
1.4. The External Dimensions
In 2005 US posted the largest current
account deficit of its history - 6.4 % of its
GDP
Due to persistent differences in saving and
investment behavior in US.
Although the euro area has a roughly
balanced current account, it would not be
immune to effects of a disorderly
correction in global imbalances.
70
1.4. The External Dimensions
71