Macroeconomics by alicejenny

VIEWS: 7 PAGES: 45

									 The impact of eurozone entry and the
experience of eurozone member states

         by David Cobham,
  Heriot-Watt University, Edinburgh

          Public lecture
        Comenius University
            Bratislava
          February 2008
                         Outline
Introduction:
• what monetary union means, costs and benefits
• some historical background to European Monetary Union
• how EMU works: the European Central Bank, its
   monetary policy strategy, monetary and fiscal policy
The performance of the Eurozone so far:
• growth, inflation
• the exchange rate of the euro
• internal variation between members
• the operation of monetary policy
The likely effects of entry:
• the Maastricht criteria
• how and why entry now is different from entry in 1999
• prospects for growth and inflation
                       Introduction

Monetary union
•  single currency (or irrevocably fixed exchange rates
   with zero margins)
•  full capital mobility
•  union-level central bank taking monetary policy
   decisions
•  foreign exchange reserves pooled and managed by
   union-level central bank

•   basic deal underlying MU: country fixes its exchange
    rate permanently against partner countries, but loses
    ability to set national interest rate
                       Introduction

Costs and benefits of monetary union
•   main cost is loss of exchange rate (and interest rate)
    as instruments of national policy
•   how big this cost is depends on factors such as (1)
    likelihood of asymmetric shocks of a kind which
    exchange rate changes can treat effectively - depends
    e.g. on whether future shocks likely to be national or
    industrial/regional, (2) openness of partner countries
    i.e. importance of trade flows between them - more
    openness makes exchange rate changes less effective
•   second cost is transitional unemployment cost of
    reducing inflation rate to the union inflation rate
                        Introduction

•   first benefit is reduction in uncertainty about exchange
    rate, which should lead to more trade and investment,
    with better international allocation of resources

•   second benefit is savings from (a) pooling of foreign
    exchange reserves - less reserves needed for sum of
    countries, (b) centralisation of monetary policy - less
    research and less decision-making needed with union,
    (c) reduction in transaction costs from single currency
                       Introduction

• third benefit is improvement in macroeconomic policy
  from restructuring of policy arrangements in move to
  monetary union, eg monetary policy becomes more
  disciplined, more credible, hence lower inflation and
  lower interest rates

• fourth benefit is increased price competition coming from
  increase in price transparency through single currency
                        Introduction
Historical background
• MU was hardly mentioned at start of Common Market
• became issue in late 1960s when Bretton Woods system
  was breaking down, Common Agricultural Policy was
  struggling with realignments of franc, mark
• formal objective of MU adopted 1969, Snake mechanism
  from 1972, but progress neither substantial nor inclusive
• 1979 European Monetary System (Giscard, Schmidt) =
  framework for stabilising exchange rates of most EU
  members (not UK, but France and Italy as well as
  Germany, also Ireland, later Spain, Portugal, Finland…)
• over time EMS becomes stronger and more successful,
  with less realignments, end of capital controls late 1980s
• fundamental decisions on European Monetary Union
  taken in Maastricht Treaty negotiations December 1991
                        Introduction
• major upheavals in European Monetary System 1992-
  93: exit of sterling (had entered only in 1990) and lira
  (returns 1996), repeated devaluations of smaller
  currencies, French franc survives but only with help of
  widening of bands, from 2.25% to 15%, in August 1993
• major currencies gradually return to pre-1992 parities,
  governments reaffirm commitment to EMU
• European Monetary Institute set up 1994 becomes
  European Central Bank from 1998, infrastructure
  including TARGET payments system established
• EMU starts operation Jan 1999; members Austria,
  Belgium, Finland, France, Germany, Ireland, Italy,
  Luxembourg, Netherlands, Spain, Portugal (but not UK,
  Sweden, Denmark), Greece from 2001, Slovenia from
  2007, Cyprus and Malta from 2008, others shortly (?)
                       Introduction
How EMU works
• union-level central bank = ECB
   – independent of EU Commission and of national
     governments, focusing on Eurozone economy
   – mandate to pursue price stability
• decisions on monetary policy taken by Governing
  Council consisting of ECB Board (6 members, President,
  Vice-President, plus 4 others, all nominated by European
  Council for non-renewable terms of 8 years) and 13
  governors of national central banks
• monetary policy strategy is careful compromise between
  monetary targeting (as practised, more or less, by
  Bundesbank) and inflation targeting (as practised and
  advocated eg by Bank of England)
                         Introduction
The relation between monetary policy and fiscal policy:
• controversial issue before EMU and since
• Maastricht Treaty criteria for entry to EMU included
  (imprecise) limits on budget deficits and debt
• the deficit limit was then incorporated in the Stability and
  Growth Pact: governments should aim to balance
  budgets over cycle, and fiscal deficits should not exceed
  3%; sanctions could be imposed on deficits over 3%
  unless mitigating circumstances e.g. severe recessions
• basic argument: need to constrain national-based fiscal
  policy so centralised monetary policy can work properly
• SGP criticised for reducing scope for national fiscal
  policy, when arguably more scope is needed because of
  lack of national monetary policy (interest/exchange rate)
                        Introduction
• under pressure from large countries refusing to observe
  SGP, revisions agreed late March 2005: 3% def and
  60% debt reference values remain, medium term budget
  objective ‘close to balance’ or in surplus, states to cut
  deficits and debt in good times, more emphasis on debt
  which should fall at sustainable rate towards 60%

• but more scope for claiming special circumstances:
  negative growth instead of -2% growth; mitigating factors
  include spending on development aid, European policy
  goals (eg research), costs of European unification
  (German reunification), major pension reforms; plus
  more time to adjust before sanctions

• issue still controversial; but revision has not produced
  feared excessive loosening of policy, may turn out okay
                 Eurozone performance
Economic growth:
- neither impressive nor disastrous, better from 2006
- but probably disappointing to those who expected EMU
   would help to stimulate growth

Chart: data on real GDP growth from OECD Econ Survey
   December 2007
- 2007 data are estimates (on partial information)
- 2008, 2009 are forecasts
- Other EU 15 = Denmark, Sweden, UK (unweighted
   average)
- Other Western Europe = Norway, Switzerland
                              Growth

5.0
                 Eurozone   Other EU 15   Other Western Europe   USA
4.0


3.0


2.0


1.0


0.0
      1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
                   Eurozone performance
Inflation:
- averages at 2.1% 1999-2007
- above ECB’s definition or price stability (inflation < 2%)
- but below US though above UK
- broadly satisfactory; more stable than USA or others

Chart: data from OECD Econ Survey Dec 2007 as above
                              Inflation

4.0
                 Eurozone   Other EU 15   Other Western Europe   USA
3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0
      1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
                 Eurozone performance
Unemployment:
- Eurozone unemployment consistently, stubbornly, higher
   than elsewhere

Chart: data for standardised unemployment from OECD
  Econ Survey Dec 2007 as above
                                   Unemployment

12.0
                     Eurozone       Other EU 15    Other Western Europe       USA
10.0

 8.0

 6.0

 4.0

 2.0

 0.0
       1996   1997   1998   1999    2000   2001   2002   2003   2004   2005   2006
                  Eurozone performance
Most striking feature is exchange rate:
- strong depreciation of euro vs dollar 1999 to mid-2001
- strong appreciation of euro mid-2001to end-2004
- renewed appreciation of euro/depreciation of dollar in
   2006, 2007
- movements against dollar are largest element in nominal
   effective exchange rate (weighted average) (2000=100)
- real effective exchange rate (relative unit labour costs)
   broadly follows nominal rate (also 2000=100)
                          Euro exchange rate
140                                                               1.6
135                Nominal effective exchange rate
                   Real effective exchange rate (ulc)
                   Euros per US dollar                            1.4
130
125
                                                                  1.2
120
115                                                               1
110
                                                                  0.8
105
100
                                                                  0.6
95
90                                                                0.4
 1996Q1   1998Q1     2000Q1        2002Q1       2004Q1   2006Q1
                 Eurozone performance
These movements are a puzzle:
- we do not understand well the movement of exchange
   rates at this frequency
- we have no convincing explanation of these particular
   movements
- they affect competitiveness of Eurozone-produced goods
   on world markets
- but these effects seem so far to be less serious than
   might have been expected
                   Eurozone performance
Internal variation between Eurozone members:
- considerable variation in growth rates, esp Ireland faster,
   Italy slower, Germany slower then improves
                   Growth rates of individual countries

11.0

 9.0
             Eurozone   France    Germany      Ireland    Italy   Spain
 7.0

 5.0

 3.0

 1.0

-1.0
       1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
                   Eurozone performance
Internal variation between Eurozone members:
- considerable variation in growth rates, esp Ireland faster,
   Italy slower, Germany slower then improves
- considerable variation in inflation rates, esp. Ireland
   initially higher, Spain higher, Italy higher, Germany
   mostly lower
                       Inflation of individual countries

6.0
               Eurozone    France     Germany       Ireland   Italy   Spain
5.0

4.0

3.0

2.0

1.0

0.0
      1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
                   Eurozone performance
Internal variation between Eurozone members:
- considerable variation in growth rates, esp Ireland faster,
   Italy slower, Germany slower then improves
- considerable variation in inflation rates, esp. Ireland
   initially higher, Spain higher, Italy higher, Germany
   mostly lower
- hence considerable variation in real exchange rates (note
   all have 2000=100, we can compare growth trends but
   not relative levels)
          Real effective exchange rates of individual countries


170
              Eurozone     France     Germany      Ireland   Italy     Spain

150


130


110


90
 1996Q1   1998Q1         2000Q1      2002Q1       2004Q1          2006Q1
                  Eurozone performance
Bond yields:
- yields on long term government bonds reflect to a large
   extent expectations of inflation, so we can use them as a
   proxy measure of the credibility of monetary policy – the
   lower the yields, the more credible the policy
- variation over time, but Euro area typically well below
   USA but above Other Western Europe
                                  Bond yields

8
                  Eurozone      Other EU 15     Other Western Europe      USA
7

6

5

4

3

2
    1996   1997   1998   1999   2000   2001     2002   2003   2004     2005   2006
                   Eurozone performance
Internal variation between Eurozone members:
- considerable variation in growth rates, esp Ireland faster,
   Italy slower, Germany slower then improves
- considerable variation in inflation rates, esp. Ireland
   initially higher, Spain higher, Italy higher, Germany
   mostly lower
- hence considerable variation in real exchange rates (note
   all have 2000=100, we can compare growth trends but
   not relative levels)
- unemployment rates, less predictably: Ireland goes well
   below Eurozone average, but Italy goes below average
   from 2003, Germany above
                     Unemployment in different countries




16.0


12.0


 8.0


 4.0
              Eurozone      France      Germany      Ireland     Italy   Spain
 0.0
       1996   1997   1998   1999     2000   2001   2002   2003   2004    2005    2006
                   Eurozone performance
How does Slovakia compare?
- since 2001 higher growth
- initially much higher inflation, but now converged
- higher unemployment, esp. since 2000
- bond yields higher but then converge

so general picture is good growth but high unemployment,
  alongside nominal convergence
                                Growth

10.0
 9.0       Eurozone   Other EU 15   Other Western Europe   USA   Slovakia
 8.0
 7.0
 6.0
 5.0
 4.0
 3.0
 2.0
 1.0
 0.0
       1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
                                Inflation

14.0
           Eurozone   Other EU 15    Other Western Europe   USA   Slovakia
12.0

10.0

 8.0

 6.0

 4.0

 2.0

 0.0
       1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
                                   Unemployment

25.0
          Eurozone      Other EU 15        Other Western Europe     USA         Slovakia

20.0


15.0


10.0


 5.0


 0.0
       1996   1997   1998   1999    2000    2001   2002   2003    2004   2005    2006
                                 Bond yields

9
            Eurozone     Other EU 15    Other Western Europe    USA        Slovakia
8

7

6

5

4

3

2
    1996   1997   1998   1999   2000   2001    2002   2003   2004   2005    2006
                  Eurozone performance
The monetary policy of the ECB:
• monetary policy strategy is careful compromise between
  monetary targeting and inflation targeting
• basic evaluation of monetary policy involves estimation
  of Taylor rule to see whether interest rate responds
  strongly enough to inflation to prevent inflation getting
  out of control
• for ECB answer seems to be yes, as for the Federal
  Reserve and the Bank of England
• policy interest rate in Eurozone less variable than US
  and UK – reflecting greater stability of inflation – and
  there is some evidence that the ECB is less ‘inertial’ than
  the Fed or the BoE, which is probably desirable
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                  Eurozone performance
The monetary policy of the ECB:
• some criticism of relative lack of transparency of ECB as
  compared to Bank of England (not to Fed)
• some concern re ‘excessive independence’ of ECB plus
  lack of accompanying political union
• but on major issues consensus is that ECB is a good
  modern central bank making sound monetary policy
  decisions on basis of proper analysis and understanding
• next few years: will it turn out that US and UK suffer from
  intensive liberalisation of 1980s-1990s, with excessive
  dependence on credit-based consumer spending, while
  Eurozone economy remains more stable and more
  robust to shocks?
                   Entry into the Eurozone
All new members of EU are expected to enter EMU in due
   course, no choice

Entry depends on fulfilment of Maastricht criteria: must
• have no 'excessive deficit’ [defined with respect to
  reference values of 3% of GDP for deficit, 60% for debt]
• keep inflation  average of 3 lowest in EU + 1.5%
• keep long term interest rates  average of those in 3
  lowest inflation countries + 2%
• have observed 'normal' exchange rate margins in EMS
  for at least 2 years [interpreted to mean 15% margins]
These criteria were originally set out as criteria for entry at
  start of EMU, and they are arguably less appropriate for
  new entrants now, but they are still applied
                  Entry into the Eurozone
Entry into Eurozone now is not same as entry of first group
  of EMU members together in 1999
• basic mechanisms now exist, monetary policy is
  operating well, new currency is well established,
  monetary-financial system is relatively stable
• so risk of entry is small compared to that in 1999
• and transactions costs of adopting euro are lower
  because e.g. Slovak firms already operate in euros
                  Entry into the Eurozone
Growth effects of entry for country like Slovakia:
• entry means fixing, permanently, its exchange rate
  against its major trading partners who are already fixed
  to each other, and using the euro over a much wider
  range of transactions, with consequent savings
• evidence suggests monetary/currency unions promote
  trade (even if some estimates are ‘too high’), by reducing
  direct and indirect (transactions costs) barriers to trade
• evidence suggests trade promotes economic growth
• on the other hand, membership of monetary union
  means can’t depreciate exchange rate to compensate for
  higher domestic inflation causing loss of competitiveness
                 Entry into the Eurozone
•   overall, provided Slovak labour markets flexible
    enough to avoid loss of competitiveness, should
    expect strong positive growth impact from entry into
    EMU
                    Entry into the Eurozone
Inflation effects of entry:

• monetary policy of Eurozone is sound and stable, so in
  general would expect continued low inflation, but two
  reasons for thinking inflation may be higher:

• first, introduction of euro notes and coin in January 2002
  was accompanied by faster rises in some prices, mainly
  those for services sold in local, monopolistically
  competitive markets: from outside and on basis of
  statistical data effect looks small and temporary, but
  many in e.g. Italy, Germany, believe it was significant: it
  may be that new entrants have same experience when
  switch to euro notes and coin [evidence for Slovenia,
  Malta, Cyprus?]
                 Entry into the Eurozone
•   second, evidence suggests prices of internationally
    tradable goods are broadly comparable in different
    countries, but prices of labour-intensive non-tradable
    services and goods tend to be systematically lower in
    lower-income countries
•   as wages in lower-income countries rise towards those
    in higher-income countries, prices of those goods and
    services rise faster and converge towards those of
    higher-income
•   this means lower-income countries experience higher
    inflation: ‘Balassa-Samuelson’ effect, 1-2% p.a.?
Entry into the Eurozone

								
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