Monetary integration

European Economic Integration
Monetary integration
Giovanni Di Bartolomeo
Sapienza University of Rome
European Economic Integration
The question… and the short answer
• Should currency area borders coincide with national borders?
- Money makes transactions immensely easier: the more
people accept a currency, the more useful it is;
- As a currency area grows larger, it becomes more diverse,
which means more costly.
• The solution has to involve trading off these costs and benefits:
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Benefits of a currency area
• Elimination of transaction costs and comparability of prices:
- If you started with one EU currency and exchanged it
successively in all the currencies of the EU (before the
Euro) and than exchanged it back into the initial currency,
you would get less than 50% of the initial amount!
• Elimination of exchange rate risk (for transactions and FDI).
• More independent central bank.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Costs of a currency area
• Diversity in a currency area is costly because a common
currency makes it impossible to react to each and every local
particularity.
• The theory of optimum currency areas (OCA) aims at identifying
these costs more precisely.
• We proceed in three steps:
1. Define and examine the effects of asymmetric shocks;
2. Study the problems of asymmetric shocks in a currency
area;
3. Examine how the effects of asymmetric shocks can be
mitigated when national exchange rates are no longer
available.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Shocks and the exchange rate
• Consider an adverse demand shock:
- The real exchange rate depreciates;
- With exchange rate and price rigidities, fall in output is much
bigger.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Shocks and the exchange rate
• Consider currency area with 2 countries (A, B) and A is hit by a
shock:
- The real exchange rate depreciates to λ2 (“correct” on
average) = common exchange rate cannot insulate both
countries;
- In the long-run, prices will adjust (PA & PB).
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
The optimum currency area criteria
• The optimum currency area (OCA) theory derive practical
criteria to understand which countries should share the same
currency.
• Three classic (economic) criteria:
- Mundell:
- Kenen;
- McKinnon.
• Three political criteria:
- Fiscal transfers;
- Homogeneous preferences;
- Solidarity vs. nationalism.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Criterion 1 (Mundell): Labor mobility
• Optimum currency areas are those within which people
move easily:
- Unemployment in A and inflationary pressures in B could
be solved by moving production factors from A to B.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
C1 (Mundell): labor mobility
• Caveats:
- Labor mobility is easier within national borders (culture,
language, legislation, welfare, etc.) than across countries;
- In presence of country specialization, skills also matter;
- Capital mobility: difference between financial and physical
capital.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
C2 (Kenen): production diversification
• Countries whose production and exports are widely
diversified and of similar structure form an optimum
currency area:
- Indeed, in that case, there are few asymmetric shocks and
each of them is likely to be of small concern.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
C3 (McKinnon): openness
• Countries that are very open to trade and trade heavily with
each other form an optimum currency area:
- Traded good prices are set worldwide;
- If all goods are traded, domestic good prices must be
flexible and the exchange rate does not matter for
competitiveness.
• Caveat:
- Exchange rate can affect profits for exporters (but
nowadays most goods have little national specificity).
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
C4: Fiscal transfers
• Countries that agree to compensate each other for adverse
shocks form an optimum currency area:
- Transfers can act as an insurance that mitigates the costs
of an asymmetric shocks;
- Transfers exist within national borders;
- The debt crisis has brought forward the issue of transfers
(i.e., moral hazard).
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
C5: Homogeneous preferences
• Currency union member countries must share a wide
consensus on the way to deal with shocks.
–Germany and Italy: a difficult relationship:
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
C6: Solidarity vs. nationalism
• When the common monetary policy gives rise to conflicts
of national interests, the countries that form a currency
area need to accept the costs in the name of a common
destiny:
- It is unavoidable that there will be times when there will be
disagreements and that these disagreements may follow
national lines: people must accept that they will be living
together and extend their sense of solidarity to the whole
union.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
Is Europe an optimum currency area?
European Economic Integration
• Labor mobility: Europeans move little!
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
Is Europe an optimum currency area?
European Economic Integration
• Diversification and trade dissimilarity = trade dissimilarity index:
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
Is Europe an optimum currency area?
European Economic Integration
• Openness = openness to trade:
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Is Europe an optimum currency area?
• Fiscal transfers:
- up until the debt crisis, there was no transfer system in the
EU;
- EU budget is small (slightly above 1% of GDP) and almost
entirely spent on operating expenses, CAP, and Structural
Funds;
- crisis led to the creation of the European Financial Stability
Fund (EFSF), which recognizes that monetary union needs
transfers.
• Homogeneous preferences:
- based on past inflation rates, it does not seem that country
share similar views on monetary policy;
- similar story when looking at public debts.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
Is Europe an optimum currency area?
European Economic Integration
• Solidarity vs. nationalism = feeling European? (2006)
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
Is Europe an optimum currency area?
European Economic Integration
• So, is Europe an optimum currency area? Mixed performance:
 The single currency project has been and remains
controversial.
 The partial fulfillment of the OCA criteria implies that, given that
the decision to go ahead has been taken, there will be costs.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Will Europe become an OCA?
• The fact that the single currency exists can change the
situation:
- effects on trade: Baldwin et al. (2008) conclude that, so far,
the euro has probably increased trade by some 5%;
- effects on labor markets: few expect labor mobility to
increase dramatically in the near future but the single
market may encourage reforms to make European labor
markets more flexible;
- fiscal transfers: much the same applies to fiscal transfers.
• BUT monetary union is not only about economics!
• Political considerations have been paramount in launching the
euro: political leaders agreed on the monetary union without
thinking in terms of the OCA theory. Their intention was to
move one step further in the direction of an „ever-closer union‟.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
The Maastricht Treaty
• Monetary union is the outcome of a deal between Germany and
the other countries. As part of it, the Maastricht Treaty included:
- a firm commitment to launch the single currency by January
1999 at the latest;
- a list of five criteria for admission to the monetary union;
- a precise specification of central banking institutions;
- additional conditions mentioned (e.g. the excessive deficit
procedure).
• Maastricht Treaty introduced, for the first time, the idea that a
major integration move could leave some countries out. It
specifies that all countries are expected to join as soon as
practical (Denmark and UK were given an exemption; Sweden
does not have an exemption but acts as if it did).
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
The Maastricht treaty: 5 entry conditions
• A selection process to certify which countries had adopted a
culture of price stability (i.e., German-style low inflation):
countries have to fulfill five convergence criteria:
1. Inflation: not to exceed by more than 1.5 percentage points the
average of the 3 lowest inflation rates among EU countries;
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
The Maastricht treaty: 5 entry conditions
2. Long-term nominal interest rate: not to exceed by more than 2
percentage points the average interest rate in the 3 lowest
inflation countries (long-term interest rates mostly reflect
markets‟ assessment of long-term inflation);
3. ERM membership: at least 2 years in ERM without being
forced to devalue;
4. Budget deficit: deficit less than 3% of GDP. Historically, all big
inflation episodes born out of runaway public deficits and
debts!
5. Public debt: debt less than 60% of GDP (average of countries).
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
The Eurosystem
• N countries with N National Central Banks (NCBs) and a new
central bank at the center: the European Central Bank (ECB).
• The European System of Central Banks (ESCB): the ECB and
all EU NCBs. The Eurosystem: the ECB and the NCBs of euro
area member countries.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Objectives
• “The primary objective of the ESCB shall be to maintain price
stability. Without prejudice to that objective, it shall support the
general economic policies in the Union in order to contribute to
the achievement of the latter‟s objectives.”
(Article 282-2)
• Eurosystem has chosen to interpret it as follows: „Price stability
is defined as a year-on-year increase in the Harmonized Index
of Consumer Prices (HICP) for the Eurozone of below 2 per
cent. Price stability is to be maintained over the medium term.‟
 Commonly understood as between 1.5 and 2%;
 Commonly understood to refer to a 2–3 year horizon.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Instruments
• Eurosystem uses the short-term interest rate: its changes have
a knock-on effect on longer-term interest rates (and thus on the
cost of credit), on asset prices (and thus on capital costs of
firms) and on the exchange rate (and thus on foreign demand
for domestic goods and services).
• The Eurosystem focuses on the overnight rate EONIA (a
weighted average of overnight lending transactions in the
Eurozone‟s interbank market):
- The Eurosystem creates a ceiling and a floor for EONIA by
maintaining open lending and deposit facilities at preannounced interest rates;
- The Eurosystem conducts, usually weekly, auctions at a
rate that it chooses, thus providing liquidity to the banking
system and the chosen interest rate serves as a precise
guide for EONIA.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Instruments
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Strategy
• Strategy relies on three main elements:
1. Definition of price stability;
• and two „pillars‟ to identify risks to price stability:
2. First pillar = economic analysis. It consists of a broad review
of recent evolution and likely prospects of economic
conditions (e.g., growth, employment, prices, exchange
rates, foreign conditions);
3. Second pillar = monetary analysis. It studies the evolution of
monetary aggregates (M3, in particular) and credit.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Independence and accountability
• A central bank must be free to operate without outside
interference but delegation to unelected officials needs to be
counterbalanced by democratic accountability.
• Eurosystem is characterized by a great degree of
independence (probably the world‟s most independent central
bank).
• Eurosystem operates under the control of the European
Parliament. Transparency contributes powerfully to
accountability.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
Independence and accountability
European Economic Integration
Independence and transparency indices:
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
The first years (until the Great Crisis)
• A difficult period:
- Oil shock in 2000;
- September 11 in 2001;
- Oil prices to record level and US financial crisis start in mid2007
• Result: inflation almost always above 2% but close to target
(until 2007) and lower than perceived.
• Growth has been generally slow in the Eurozone, prompting
criticism of the ECB, including by some member governments.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
The first years (until the Great Crisis)
European Economic Integration
Inflation in the Eurozone (%), 1999Q1–2008:
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
The first years (until the Great Crisis)
European Economic Integration
Average annual GDP growth rate (%), 1999–2008:
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
The first years (until the Great Crisis)
• Exchange rate: from too weak to too strong? But Eurosystem
does not manage exchange rate: the euro is a freely floating
currency.
• The dollar/euro exchange rate, January 1979–September 2008:
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
The first years (until the Great Crisis)
European Economic Integration
Asymmetries: some evidence of decrease:
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
The first years (until the Great Crisis)
• Still, large inflation differentials have occurred:
- Lower than average: Germany, France and Finland;
- Higher than average: Ireland, Spain, Portugal, Netherlands
and Italy.
• Possible causes:
- Catching up in productivity levels;
- Wrong initial conversion rates;
- Autonomous wage and price setting;
- Policy mistakes, such as fiscal expansion;
- Asymmetric shocks, such as oil price effects.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
New EU members and EMU
• New EU members do not have an opt-out so they are formally
required to join the Eurozone “as soon as possible.”
• They must meet the five convergence criteria, assessed by
Convergence Reports.
• The latest extensive report was issued in May 2008 and
included the ten countries with a derogation (Bulgaria, the
Czech Republic, Estonia, Latvia, Lithuania, Hungary, Poland,
Romania, Slovakia and Sweden): only Slovakia met the
conditions to join the euro area in January 2009 (for Sweden,
this is intentional since it does not want to join the ERM).
• In 2010, a report concerned just Estonia, which was found to
meet the requirements for joining the euro area.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)