The Theory of Economic and

Monetary Union. The Eurozone crisis

Lecture nr. 3 (part 2)
Ioana Negru
 Characteristics of Regional Economic Forms of Integration
Type of Lower Free trade Common Free Harmonisation of
Agreement barriers among external movement of fiscal and
among members trade capital and monetary policies
members barriers labour
Preferential ◆◆
Trading
Agreements

Free Trade Areas ◆◆ ◆◆

(e.g. NAFTA)

Customs Union ◆◆ ◆◆ ◆◆
(EU-Turkey)

Common Market ◆◆ ◆◆ ◆◆ ◆◆
(EU)

Economic Union ◆◆ ◆◆ ◆◆ ◆◆ ◆◆
(EU, US)
 The long road to EMU
• The 1969 Hague Summit: the intention to
proceed towards EMU as a long-term objective
(by 1980);
• Germany and Netherlands maintained that
before proceeding to monetary unification it was
first necessary to reach a certain level of
convergence or economic performance;
• In contrast, the monetarist countries (France,
Benelux) argued that the first step should be to
narrow exchange rate fluctuations (convergence)
 The long road to EMU
• 1970 Werner Report: proposed a 3 stage move to
full EMU by 1980 with rates of exchange fixed
and the adoption of a single currency;
• Monetary turbulences in 1971, these involved a
devaluation of the $ by 7.9% against gold, an
adjustment of EC currencies against the $ and a
return to fixed exchange rates with +/- 2.25%
around central rates;
• In 1972, Ec six plus UK, Denmark, Ireland, Norway
formed the ‘snake in the tunel’ but in 1973 this
collapsed and currencies float against the $ again
 The long road to EMU
• EMS (European Monetary system) introduced in
1979;
• Characteristics:
• A) the exchange rate mechanism
• B) the Introduction of the European currency unit
(ECU);
• C) a divergence indicator designed to ensure that
adjustment was symmetrical
• EMS= a system of fixed but adjustable exchange rates
with a target band of fluctuation (1979-1993) was +/-
2.25%; then +/-15% from 1993
 The long road to EMU
• EMS: Phases of Operation:
• 1. 1979-1983: unstable monetary environment
due to the second oil crisis;
• 2. 1983-1987: few-re-alignments; empirical
evidence suggests EMS has a stabilizing effect
on exchange rates and that there was a
convergence towards lower inflation rates; the
average rate of inflation fell from 11.6% in
1983 to 2.3% in 1986.
 The long road to EMU
• 3. 1987-1992: great stability, quite rigid fixed exchange
rates, extended the ERM membership to Spain, Uk and
Portugal, only Greece was not participating;
• 4. 1992 crisis – until 1999 and the introduction of
Euro: the currency crisis of 1992. Three events
contributed to the widening of band fluctuations to
+/-15% in 1993:
• A. liberalization of capital movements;
• B. the early difficulties encountered by Maastricht
Treaty;
• C. German reunification (tightening of monetary
policy, other members unwilling to follow)
 The long road to EMU
• Maastricht Treaty: treaty set out convergence criteria to be
met before a country could participate in the EMU (3
stages + institutional features such as ECB).
• Convergence criteria:
• A. inflation rates no more than 1.5% above the average of
the 3 countries with the lowest inflation rate in the
community;
• B. long-term interest rates should be no more that 2%
above the average of the 3 lowest inflation countries;
• C. the exchange rate should remain in the +/-2.5% band
and from August 1993 +/- 15%;
• D. Public debt must be less than 60% of GDP and budget
deficit must be less than 3% of GDP.
 The long road to EMU
• 3 stages of EMU:
• 1. July 1990-December 1993: to liberalize capital
movements between EU members, to introduce
long-run convergence programmes
• 2. 1 Jan 1994- Dec. 1998: encourage
convergence, institutions and to choose which
countries should participate;
• 3. 1 Jan 1999- a 3 years transition period, during
which currencies of the countries participating in
EMU continue to exist; 1 Jan 2002 euro notes and
coins introduced
 Maastricht Treaty Criteria
• Maastricht Treaty: treaty has established convergence
criteria that need to be met by a country to be part of EMU
(3 phases and institutional traits of ECB).
• Convergence criteria:
• A. Rate of inflations that are not over 1.5% above the
average of the three countries with the lowest inflation rate
in the community;
• B. interest rates on long term should not be over 2% above
the average of the three countries with low inflation;
• C. the exchange rate should be in the interval +/-2.5% and
from August 1993 +/- 15%;
• D. The public debt must be 60% din PIB and the public deficit
lower than 3%
 Eurosystem
• European Central Bank and the national
central banks of all EU member states.
• Tasks: 2% inflation target, price stability
• To support the general economic policies of
the community;
• To define and implement the monetary policy.
 Optimum Currency Areas (OCA)
• OCA= group of separate countries, in which all
member states profit economically from
participation; in practice, they need to benefit
in a narrow economic sense;
• Without a coordinated federal political
structure within EMU, this lack of national
monetary and exchange rate policies could
easily make fiscal policy overloaded and end
up in a public sector debt crisis
 OCA
OCA=
a group of countries that maintain their
separate currencies but fix the exchange
rates between themselves; they also
maintain full convertibility among their
currencies and flexible exchange rates
towards third countries; or may adopt a
common currency that floats against
third currencies
 Common currency area
• Is a geographical area through which one currency
circulates and is accepted as the medium of
exchange. This is also called A Currency Union or a
monetary union
• European Monetary Union came into existence on
1st January 1999: Belgium, Germany, Spain, France,
Ireland, Italy, Luxembourg, Netherlands, Austria,
Portugal, Finland, Greece, Slovenia, Cyprus, Malta,
Slovakia, estonia, Latvia and Lithuania
• Monetary policy implemented by ECB (European
Central Bank) based in Frankfurt
 OCA: Costs and benefits
• Benefits:
• 1. a reduction in transaction costs involved in
trade between members of the common
currency area;
• 2. Reduction in price discrimination (this
argument assumes transparency in prices that
results from a common currency will lead to
arbitrage in goods across CCA, so that people will
buy goods when they are cheaper and reduce
their demands where goods are more expensive
 OCA: Costs and benefits
• 3. reduction in foreign exchange rate volatility:
a third argument relates to the decrease in
exchange rate variability and the consequent
reduction in uncertainty that results from
having a single currency.
• Costs:
• 1. loss of monetary policy sovereignty;
• 2. asymmetric demand shocks
• 3. asymmetric Supply shocks
• 4. loss of fiscal sovereignty;
 Theory of Optimum Currency Area
• Attempts to set down criteria for a group of countries – if criteria
would be satisfied it would in some sense be optimal for the
countries to adopt a common currency, optimal in sense of
benefits outweigh the costs;
• Characteristics that reduce the costs:
• A. the main cost is loss of monetary policy autonomy as well as
ruling out the possibility of macroeconomic adjustment through
exchange rate movements
• B. Real wage flexibility:
• C. wage mobility;
• D. Capital mobility
• Characteristics that increase the benefits of single currency
• A. High degree of trade integration
Is Europe an Optimum currency area?
• Many European countries have a high degree
of intra-union trade and have economic cycles
that are more or less synchronized; labour
mobility and wage flexibility is low and retail
financial markets remain highly segregated at
national level
• But the countries still retain fiscal policy
independence
• Countries can have fiscal federalism but the
problem is the critique of federalism
 Stability Growth pact (SGP)
• SGP not only laid down strict rules on budget deficits
and debt-to GDP ratio for EMU members but it also
stipulated rules of punishment , fines of 0.5% of GDP;
• SGP: A. members should aim to achieve balanced
budgets;
• B. members with a total budget deficit of more than
3% of GDP incur fines unless the country experiences
a strong depression in which GDP declines by 2% in a
single year
• The rationale for SGP is to rule out free-rider or
moral hazard associate with excessive borrowing
 Stability and Growth Pact
• Suppose that a country was unable to balance
the budget; given long-run European growth
rates of 2.5-3%/year and an inflation of 2-
2.5%/Year the average Euro area could expect
long-run nominal GDP growth of about 5%/year.
B/Y=(x+i)D
Where B= total budget deficit; y=GDP; X =rate of
growth of real GDP; i=inflation rate; d= equilibrium
rate to GDP ratio
If x+i= 0.05 And D=0.6 then B/Y= 0.05*0.6= 0.03
 OCA
• Reducing the risk of assymetric shocks:
• Symmetric disturbances ⇒ business cycle correlation
• High trade integration leads to higher income correlation
• Product diversification in the region

• Dampening the effects of assymetric shocks:

• Labor mobility
• Price flexibilty ⇒ wage flexibilty
• High trade integration
• Fiscal federalism
 EMU-USA
• Labor mobility:
• Currently 1.9% of labor force in EU countries comes
from another EU member state. In the U.S., 1,5%
of population are moving inter-state every year!

• Fiscal Federalism:
• If a U.S. state suffers an income shock, it will be
compensated for 40% of the loss by fiscal
federalism (less taxes, more subsidies).
The EU budget is limited to 1.27% of EU-GDP.
 OCA
• A higher level of integration will lead to some
convergence of consumer tastes and preferences;
Krugman (1990, 1993) argues integration implies
centrifugal forces leading to the concentration of
industry, asymmetric shocks may affect the poles of
development; Kenon (1969) proposed that a
criterion for a country to join an OCA was that the
production and exports of member states should be
diversified and of a similar structure; if countries are
specialised in the production of narrow range of
products they are more vulnerable to asymmetric
shocks
 OCA
• Frankel and Rose (1980): more trade
integration is strongly associated with more
correlated economic activities between
countries;
• Artis and Zhang (1995) argue that as European
countries become more integrated their
business cycles become more synchronised.
 Uk and the Euro
• 5 economic tests:
• A. convergence: are business cycles and economic
structures compatible ?
• B, flexibility: if problems emerge, is there sufficient
flexibility to deal with them?
• C. investment: would the adoption of euro create better
conditions for firms taking long-term decisions to invest
in UK?
• D. how should adopting the euro affect financial
services?
• E. would adopting the euro help to promote higher
growth, stability and increase in jobs
 Current Account

Orange France; grey Germany; yellow Greece, blue Italy, green Spain
Trade Balance
Exports of goods and services as % of GDP
Private Debt (non-financial corporations and
households)
Public Debt
Nominal Interest rates
Real Interest rates
German Balance of Payment stats
Primary Balance as % of GDP, selected EMU
countries
Aggregate Bank balance sheets as % of GDP
Domestic bank lending as % GDP
Domestic Bank deposits as % of GDP
Investments as % of GDP
Consumption as % of GDP
Unemployment rate