THE RUN-UP TO
THE EURO:
THE MAASTRICHT
CRITERIA
Week 5
Chapter 7
THE BASIC CONCEPT
1) EU: freedom of circulation of capital (“second
floor”) and goods/services (“first floor”).
• One affects i, the other affects .
2) Which exchange rate regime?
• a) Flexible. The resulting high volatility would
have damaged stability, growth, investment.
• b) Fixed. In presence of 1), you cannot
accomodate pressures coming from differentials
in i and .
• The “inconsistent quartet” :
- freedom of circulation of goods/services
- freedom of circulation of capital
- fixed exchange rate system
- independent monetary policy.
YOU HAVE TO GIVE UP ONE OF THEM.
• If you fix one price of currency (E) you must
harmonize also the remaining two (i and )
• Coupled with:
• a) microeconomic benefits (elimination of
transaction costs, elimination of exchange rate
risks)
• b) all benefits from second floor (common
market) couldn’t be fully achievable without a
single currency (one supermarket, different coins
each shop)
• c) foundations of the builiding. If the ultimate
objective somewhere down in history is a closer
political union (sharing institutions and political
legittimacy), maybe we could start by sharing a
currency….
FEBRUARY 7° 1992, in Maastricht (Netherlands): a
decision to adopt a single currency (called “euro”
in December 1995) was formally adopted.
THE MAASTRICHT CRITERIA
• What should countries do if they want to adopt a
single currency?
• Remember the three prices of the currency:
• - interest rate (i)
• - inflation rate ()
• - exchange rate (E)
• Monetary union means to fix irrevocably E, so
some convergence criteria must be needed on
the other two.
• In this way, the single currency can be adopted
with no consequences on the overall
macroeconomic environment.
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5
FIRST CRITERION: INFLATION
Each candidate country should have an inflation
rate less or equal to the average of three lowest
inflation rates in the group of candidate countries
plus a 1.5%.
Example:
Country A : =3.2%
Country B : =2.5%
Country C: =4%
Country D: =1.7%
Country E has to have inflation less or equal to
4.35%.
First reason
• 1) We saw that a fixed exchange rate system
cannot be maintained in the presence of strong
inflation differentials.
• The resulting pressure on the exchange rate
(coming from more/less demand for national
goods and services) cannot be accomodated by
changing E.
• This is even more true in case of a monetary
union, which can be see as the strongest of the
fixed exchange rate systems.
Second reason
• Normally, a country has three tools to increase
the competitiveness of their exports and compete
on markets:
• 1) Improve the quality of their products.
• 2) Produce at lower costs, so to sell at lower
prices (i.e. having low inflation).
• 3) Use the exchange rate to artificially gain
competiveness (depreciation/devaluation)
• Once in the euro ,3) disappears. 1), we know, it’s
not easy. If we don’t set some “common initial
conditions”, the race is going to be falsed.
Third reason
• Inflation / unemployment trade-off.
• In the long-run, unemployment level is not
determined by any nominal or short-term factors;
it’s the natural rate of unemployment
(corresponding to the natural rate of output/
potential output), determined by:
1) total factor productivity
2) population growth
Inside 1): R&D expenditure, human capital
formation, macroeconomic and political stability,
property right protection, correct functioning of
markets……STRUCTURAL FACTORS.
• In the short-run, there is a
inflation/unemployment trade off:
• If a country is hit by a negative supply shock on
GDP (oil crisis), a central bank faces this choice:
• 1) To stabilize GDP and thus unemployment (by
stimulating the economy) and let inflation raise,
following the expansionary move.
• 2) To stabilize inflation (by keeping constant /
reducing aggregate demand) at the expense of
GDP.
• Or any point between these two extremes.
• It all depends on the preferences of the
central bank with regard to inflation and
unemployment.
• Germany has always had a strong preference for
inflation stabilization (hyperinflation in the 20s).
German inflation has always been very low, and
the Bundesbank acquired reputation of “tough
central bank”.
• Italy has always had a strong preference for
unemployment stabilization (Southern Italy). As
a result, Italy has always had high inflation, and
Italian monetary authority has always been
considered “soft” on inflation.
• In other words: a country’s inflation rate is an
indicator of the central bank’s preferences
on the inflation/unemployment trade-off.
• So if countries are about to form a monetary
union, they also are about to “merge” their
national central banks into one, which will be in
charge of managing inflation-unemployment
trade off at the EU level.
• So, before merging, they have to agree on which
policy stance they are going to have towards
inflation.
• They have to harmonize the central
banks’preferences, and setting a convergence
criteria for inflation is the best way to make sure
that each country enters the monetary union
(and thus participate in the creation of the
common central bank) with the same preferences
about inflation.
• REMEMBER BARRO-GORDON FOR A FORMAL
SECOND CRITERION: INTEREST
RATES
Each candidate country must have a long-term
interest rate less or equal to the average
observed in the three low-inflation countries +
2%
Example:
Country A : i=5.21%
Country B : i=4.79%
Country C: i=6.85%
Country D: i=5%
(A,B,D are the lowest-inflation countries)
Country E has to have inflation less or equal to 7%.
• Excessive long-term interest rate differentials prior to the
entry in the EMU can cause large disturbances on financial
markets (capital gain/losses).
• Example: suppose UK long-term bond rate is 5% at the
moment of joining EMU, while the average long-term bond
rate in euro is 4%.
• At the moment of entry, the euro-sterling rate will be fixed
irrevocably.
• Since there is no exchange risk involved, bondholders will
arbitrage (sell the euro bond and buy the UK bond) until
the returns on both are equalized.
• This process will lead to a drop in the price of euro bond
and to an increase in the price of sterling bond.
• Those who had euro bonds in their portfolio will make huge
capital losses, and those who had sterling bond will make
capital gains.
THIRD CRITERION: ECHANGE RATE
STABILITY
Each candidate country should maintain its
exchange rates within the 'normal' EMS bands
of fluctuation (15% upward and 15%
downward) during the two years preceding
their entry into the EMU.
Why?
In order to avoid artificial manipulation of the
exchange rates so to enter the euro with more
favourable conditions (i.e. a country with
difficulties in the export sector might be
tempted to manipulate markets so to enter
EMU with a lower E, so to gain
competitiveness)
• For new comers, the relevant exchange rate
agreement is the EMS II.
• EMS II is a exchange rate agreement between
euro-zone and non-euro EU countries.
• Denmark, Baltic States (Estonia, Lituania,
Latvia), Slovakia.
• Slovenia, Ciprus and Malta left EMS II to enter
EMU between 2007 and 2008. Slovakia entered in
2009.
• Sweden and UK refused to entry even in the EMS
II.
FOURTH CRITERION: PUBLIC FINANCE
• Consistently with the three-prices view, the first
three Maastricht criteria set convergence for:
• - interest rate
• - inflation rate
• - obviously exchange rates
• But this is not enough.
• We must ensure that all other variables that
can potentially put pressure on i and  are
taken care of.
4.1 DEBT/GDP CONVERGENCE
• Public deficit = G – T +iB
• Primary public deficit= G-T
• Public debt = stock of bond issued by the
government to finance deficit
• What’s the connection between those variables
and interest rate or inflation?
• High debt puts upward pressure on:
• 1) inflation rate
• 2) interest rate
And thus indirectly violates criteria 1 and 2.
Why?
DEBT-INFLATION
• High-indebted government have a strong
incentive NOT to fight inflation.
• Inflation benefits borrowers and damages
lenders, because it erodes the real value of the
loan.
• If I borrow 100 euro at 4% interest rate, if
inflation goes up from 1% to 3% I only give back
101 in real terms.
• Who is the biggest borrower in the economy?
• The government, when issue public debt.
• So high-indebted government have incentive to
“inflate the debt away”, and this is in contrast
with the first criterion.
DEBT-INTEREST RATE
• 1) When the government issues more debt, it
puts upward pressure on the interest rate in the
capital market, since demand for funds increases
(and so the price of money increases).
• 2) It also increases the interest rate via the
increase in the risk premium; since the debt
exposure increases, financial investors will
require a higher return (interest rate) in order to
protect themselves from default risk.
ABSOLUTE OR RELATIVE VALUES?
•
•
•
•
•
•
•
We are not interested in absolute values (B or D).
We are interested in relative values (B/GDP, D/GDP).
Family A and Family B both own 15.000 euro.
Family A’s annual income is 30.000 euro.
Family B’s annual income is 150.000 euro.
Which one is in deeper trouble?
Family A, because it is indebted for 50% of their income,
whereas family B only for 10%.
• So, Family A’s situation is more dangerous, because their
debt exposure is higher with respect to their capability to
pay the debt back.
FAMILIES OR COUNTRIES?
• The equivalent for countries….
• DEBT/GDP
DEFICIT/GDP
• The stock of debt (or the deficit flow) compared
to a country’s income.
• This measure also suggest an alternative way to
improve public finances: not only to decrease the
numerator (issuing less debt / reducing deficit
byspending less or taxing more), but also to
increase the denominator will work.
• Namely….promote GDP growth!
FOURTH CRITERION: PART 1
• Each candidate country should have a
government debt less or equal to 60% of GDP. If
this condition is not satisfied, government debt
should diminish sufficiently and approach the
reference value at a satisfactory pace.
• Why 60% ?
• Because it was the average value of debt/GDP
ratios of member states at that time.
• Italy and Belgium benefited from the clause.
FOURTH CRITERION:PART 2
• Each candidate country must have a deficit/GDP
ratio less or equal to 3%.
• Why 3%?
 g 
dt  
 bt 
 1 g 
• d= deficit / GDP (D/Y)
• b= debt/ GDP (B/Y)
• g= rate of growth of GDP
to stabilize b=60%
per stabilizzare il rapporto debito/Pil al 60%
0.045
0.04
rapporto deficit/Pil necessario
0.035
0.03
0.025
0.02
0.015
0.01
0.005
0
0
0.01
0.02
0.03
0.04
0.05
0.06
tasso di crescita del Pil nominale
0.07
0.08
If I have (nominal) g= 5%
in presenza di una crescita nominale del 5%
0.5
0.45
deficit/Pil necessario
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.2
0.3
0.4
0.5
0.6
0.7
rapporto debito/pil scelto
0.8
0.9
1
If I have d=3%
in presenza di un deficit/Pil al 3%
0.12
0.11
crescita nominale necessaria
0.1
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.2
0.3
0.4
0.5
0.6
0.7
rapporto debito/Pil scelto
0.8
0.9
1
SO….
• A deficit / GDP limit of 3% succeeds in stabilizing
debt/GDP at 60% ONLY IF nominal growth of
GDP is at least 5%.
• Real growth = nominal growth – price growth
• Real growth= nominal growth – inflation
• With a inflation target=2%
• THE FOURTH MAASTRICHT CRITERIA IS BASED
ON THE ASSUMPTION OF REAL GROWTH OF
OUTPUT = 3%
• And, obviously, on the desire to stabilize
debt/GDP ratio at the average level of EMU
member states (60%).
• When we look at the Stability and Growth Pact
(week 6 and 7), we will analyse the
consequences of this ambitious assumption about
the growth capabilities of European national
economies.
AFTER SPRING BREAK
• Maastricht criteria and EMU enlargement
YOUR PRESENTATIONS ON COUNTRIES’REPORTS
• SGP AND ITS REFORM
• COMMON FISCAL POLICY
• THE EURO AND THE FINANCIAL MARKET