European Monetary Integration and Economic Policy What is money European Monetary Union

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					European Monetary Integration and
 Economic Policy Co-ordination:
         An Overview

                              Slide 1
  Bretton Woods
European Monetary
                    Slide 2
        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
                                                        Slide 3
       Bretton Woods Regime
       (fixed exchange rates)
• Consequences
  – dollar becomes the international currency
    (international dollar standard or gold exchange
  – dollar takes on role of reserve currency (interest
  – Central Banks must intervene in foreign
    exchange markets to stabilise the exchange rate
    of their currencies by buying and selling dollars
                                                  Slide 4
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
  – 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:
                                                              Slide 5
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 fiscal and monetary
        policies (Vietnam war)
   – Two effects
      • Purchasing power value of US$ falls
      • Other countries “import” American inflation.
   – 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”).
                                                          Slide 6
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
  – In this context, the European Monetary System (EMS)
    is born.
  – 1976: Jamaica Agreements (official end to Bretton-
    Woods period)

                                                     Slide 7
   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
   – 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.      Slide 8
   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.                       Slide 9
   First Steps Towards European
        Monetary Integration
• In December 1958, after many European currencies had
  become convertible, EPU replaced by European Monetary
  Agreement (EMA) between OEEC member countries.
• The EMA was essentially a “code of behaviour designed
  for an environment of convertibility” (Ungerer (1997)).
  Credit for balance of payments financing was no longer
  automatic but had to be negotiated in each case, and when
  granted, had a maturity of at most two years. The EMA
  was ended by the OECD Council in December 1972.

                                                      Slide 10
  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);                   Slide 11
   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
• 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 67-73.
• A Monetary Committee was created with a purely advisory
                                                       Slide 12
    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
• In the end, the Bundesbank was obliged to stop its restrictive monetary
• and a revaluation of the Deutsche Mark occurred.                  Slide 13
   First Steps Towards European
        Monetary Integration
• 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?.

                                                       Slide 14
  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
        union followed by economic convergence        Slide 15
  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 view”

                                                            Slide 16
  First Steps Towards European
       Monetary Integration
• Werner project endorsed by European Council in
  1971 but... was overtaken by events
• 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 $)                   Slide 17
         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.
                                                         Slide 18
   How EMS addressed Bretton-
    Woods 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

                                               Slide 19
               The ECU
      A basket of all EC currencies

Belgian franc = Belgian (3.301) and Luxembourg (0.13) franc   Slide 20
   How EMS addressed Bretton-
    Woods 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.
                                                         Slide 21
   How EMS addressed Bretton-
    Woods Regime Problems
• Asymmetry (cont’d)
  – obligatory and unlimited intervention at the
    • 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 22
   How EMS addressed Bretton-
    Woods Regime Problems
• Asymmetry (cont’d)
  – obligatory and unlimited intervention at the margin
     • 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?
                                                       Slide 23
   How EMS addressed Bretton-
    Woods 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
                                                 Slide 24
   How ERM addressed Bretton-
    Woods 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.
                                                        Slide 25
    How ERM addressed Bretton-
     Woods 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

                                                  Slide 26
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
                                                       Slide 27
Functioning of ERM of EMS
• Four phases in the functioning of the ERM

                                              Slide 28
Functioning of ERM of EMS

  12                                                    Netherlands






       1950-1972   1973-1978    1979-1985   1986-1991     1992-1998

                                                                      Slide 29
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.

                                                       Slide 30
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 Bretton-Woods

                                                     Slide 31
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 re-
     • 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
                                                        Slide 32
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
     • the criteria for membership
  – Stage Three: monetary union

                                                      Slide 33
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

                                                Slide 34
Criteria for membership (cont’d)

2. Government debt may not exceed 60% of
   Gross Domestic Product.
   If it does, the Commission should take into
       - whether the ratio is diminishing
              sufficiently and
       - approaching the reference value at a
              satisfactory speed.

                                                 Slide 35
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

                                                Slide 36
Criteria for membership (cont’d)

4. Long term interest rates (on long-term
   government bonds or comparable assets) shall not

   over the year preceding examination,

   by more than 2%
   that of, at most, the 3 best performing Member
   States in terms of inflation rates.

                                                Slide 37
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

  It shall not have devalued its currency against any
  other Member State's currency on its own initiative for
  the same period.
                                                  Slide 38
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.

                                                Slide 39
      Transition to Membership

• Public finances consolidation
• 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

                                             Slide 40
          Cost – Benefit Analysis
Costs                        Benefits
• Loss of exchange rate as   •   Elimination of exchange rate risk
  adjustment mechanism       •   More price transparency
• Loss of monetary policy    •   Price stability
  independence               •   More trade
• (Partial) loss of fiscal   •   Lower interest rates
                             •   International role of the currency
• Conversion costs
                             •   Stronger position in international
                                 policy negotiations

 ∑ costs > ∑ benefits ?

                                                             Slide 41
European Monetary

                    Slide 42
1. One Currency
• Creation of a Euro-area
• Transition period from 1 January 1999 to 31
  December 2001
  – because of time needed to print notes, mint
    coins and adapt banking systems.
• Legal Framework
  – Council Regulation 974/98 of 3 May 1998
  – Council Regulation 110397 of 17 June 1997
                                                  Slide 43
Situation of “Pre-ins” or Outs
• Opt-out countries
  – United Kingdom and Denmark
• Countries with a derogation
  – those that have not satisfied the convergence
  – Sweden
     • joined EU too late to obtain an opt-out
     • still does not satisfy exchange rate and legal
       convergence criteria (chooses not to do so)
  – Greece (joined on 1st Jan. 2001)
  – New Member States are countries with a
                                                 Slide 44
2. One Monetary Authority
• Single currency  single monetary
  – Federal Reserve System in USA
     • Federal Reserve Banks, Board of Governors
  – Bundesbank in Germany
     • Land Central Banks, Bundesbank
        – Land Central Banks redefined as Regional Offices (2002)
  – European System of Central Banks (ESCB) in
     • National Central Banks (NCBs) of all Member
       States, plus European Central Bank
                                                           Slide 45
2. One Monetary Authority
• Two models of Central Bank design and
  – 1. The “Anglo-French” model.
        – The Central Bank is subject to the authority of the
          government (mostly through the Ministry of
        – The Central Bank must simultaneously take into
          account several objectives, mainly price stability,
          growth and unemployment.
  – 2. The German model
        – The Central Bank is politically independent
        – Its primary objective is price stability
           » and output and employment goals as long as there is
             no prejudice to price stability
                                                        Slide 46
Objectives and Tasks of ESCB
• Primary objective
  – price stability
• Subordinate Objective
  – without prejudice to the primary objective, to
    support the general economic policies in the
  – with a view to contributing to the achievement
    of the objectives of the Community
                                              Slide 47
Objectives and Tasks of ESCB
• Tasks of the ESCB
  – define and implement the monetary policy of the
  – conduct foreign exchange operations, hold and manage
    foreign exchange reserves of the Euro-area countries
  – promote the smooth operation of the payments system
    (TARGET = Trans-European Automated Real-time
    Gross settlement Express Transfer system)
  – contribute to prudential supervision and stability of
    financial system
                                                    Slide 48
Organisation of ESCB
                          Euro System
13 “out” NCBs      12 “in” NCBs         ECB


                    Governing Council

 General Council

   European System of Central Banks (ESCB)
                                                Slide 49
Organisation (cont’d)
• Governing Council
  – composition
     • all the members of the Executive Board (6) and the governors
       of the NCBs of the Member States without a derogation
  – appointment: minimum five years renewable
  – main tasks
      adopt guidelines and take decisions necessary to ensure
       performance of tasks entrusted to the Eurosystem;
      formulate the monetary policy of the euro area, incl., as
       appropriate, decisions relating to intermediate monetary
       objectives, key interest rates and supply of reserves in
      establish the necessary guidelines for their implementation
  – composition has implications for decision making

                                                                Slide 50
Organisation (cont’d)
• Executive Board
  – composition
     • President, Vice-President and four other members, all
       chosen from among persons of recognised standing and
       professional experience in monetary or banking matters.
  – appointment: eight years non-renewable
  – main tasks
      implement monetary policy in accordance with the guidelines
       and decisions laid down by Governing Council of ECB and, in
       doing so, give the necessary instructions to the NCBs; and
      to execute those powers which have been delegated to it by the
       Governing Council of the ECB

                                                               Slide 51
Organisation (cont’d)
• General Council
  – composition
     • President, Vice-President and governors of NCBs of
       all 25 Member States
  – main tasks
     • tasks which the ECB took over from the EMI and
       which, owing to the derogation of one or more
       Member States, still have to be performed in Stage
       Three of Economic and Monetary Union (EMU).
     Plus (see below)

                                                     Slide 52
Organisation (cont’d)
    The General Council also contributes to:
     the ECB's advisory functions;
     the collection of statistical information;
     the preparation of the ECB's annual reports;
     the establishment of the necessary rules for standardising the
      accounting and reporting of operations undertaken by the
     the taking of measures relating to the establishment of the key
      for the ECB's capital subscription other than those already laid
      down in the Treaty;
     the laying-down of the conditions of employment of the
      members of staff of the ECB; and
     the necessary preparations for irrevocably fixing the exchange
      rates of the currencies of the Member States with a derogation
      against the euro.
 – problem: the role of the “out” NCBs
                                                                Slide 53
Independence, Accountability and
When exercising the powers and carrying out the tasks and
duties conferred upon them by this Treaty and the Statute of
the ESCB,
neither the ECB, nor a national central bank, nor any member
of their decision-making bodies
shall seek or take instructions from Community institutions or
bodies, from any government of a Member State or from any
other body.
The Community institutions and bodies and the governments
of the Member States undertake to respect this principle and
not to seek to influence the members of the decision-making
bodies of the ECB or of the national central banks
in the performance of their tasks.
                                                        Slide 54
2.3 Independence, Accountability and
•Different Kinds of Independence
    – personnel, financial, and policy
•Why independence?
•How is independence insured?
    – security of tenure
    – formally, accountable to no person or institution
    – the degree of genuine understanding of the monetary
      policy process and policy decisions by the public

                                                          Slide 55
3. One Monetary Policy
• preparatory work done by European
  Monetary Institute, precursor of European
  Central Bank

                                         Slide 56
The Monetary Policy Strategy of
the ESCB
• Specification of the primary objective of
  price stability
  – a year-on-year increase in the Harmonised
    Index of Consumer Prices (HICP) for the euro
    area of below 2%
     • why HICP? because only harmonised index
       available !!
     • increase (so no deflation)

                                            Slide 57
       Monetary Policy Strategy
• A strict focus on price stability
  – The ECB has interpreted its dual mandate in a
    highly idiosyncratic way.
     • “maintaining price stability in itself contributes to
       the achievement of output and employment goals
        – (Monthly Report, January 1999, p.40)
     • this reduces its dual mandate to a single one
        – and narrows down its responsibility, and does not
          require of it a balancing act.
  – Price stability has been interpreted as a
    medium-run objective                               Slide 58
       Monetary Policy Strategy
• A low target range for inflation
  – The ECB has interpreted “price stability” to
    mean that inflation should stay between 0%
    and 2%
  – In May 2003, the ECB reviewed its monetary
    policy, and “clarified” its price stability goal as:
     • maintain inflation rates close to 2% over the medium

                                                       Slide 59
Inflation Rate Mostly Above Upper Limit of 2%

                                        Slide 60
       Monetary Policy Strategy
• The “two pillar” framework for the
  assessment of the risks to price stability
  – an “economic analysis” pillar (short term)
     • assessment of current economic developments and
       associated short to medium-term risks to price stability.
       Includes an analysis of shocks hitting the euro area
       economy and projections of key macroeconomic
  – a “monetary analysis” pillar (medium term)
     • developments in a wide range of monetary indicators
       including M3, its components and counterparts, notably
       credit, and various measures of excess liquidity.
                                                         Slide 61
       Monetary Policy Strategy
• The “two pillar” framework for the
  assessment of the risks to price stability
  – a “monetary analysis” pillar
     • a “reference value” for the rate of growth of the
       monetary aggregate, M3, is calculated on the basis of
       the quantity theory of money:
         – rate of growth of money stock
           = inflation rate + trend growth rate of output – rate
           of change in velocity of circulation of money
           = (below 2 %) + (2 % to 2.5 %) – (-0.5 % to –1 %)
           = (more or less) 4.5 %
                                                          Slide 62















                                                Rate of growth of M3 (“reference value: 4.5%)
                                                                                                Monetary Policy Strategy

Slide 63
Monetary Policy Instruments
• a. Standing facilities
   – marginal lending facility (ceiling)
     • no bank will borrow for more
  – deposit facility (floor)
     • no bank will lend for less

                                           Slide 64
Monetary Policy Instruments (cont’d)
  • b. Open market operations
     – buying and selling government bonds to
       “counterparties” (financial institutions
       with whom the ESCB deals directly)
     – open market operations allow the Central
       Bank to steer the interest rate within the

                                             Slide 65
Monetary Policy Instruments (cont’d)
  • c. Minimum Reserves
    – banks have to deposit at the ESCB a certain
      percentage of the deposits they themselves
      receive from clients.
      Which means that liquidity is withdrawn from
      the system.
      But also affects the profitability of banks who
      are paying interest on these deposits to clients
      but cannot lend them to others.

                                                   Slide 66
4. Exchange Rate Policy
• Who is responsible ?
  – It is the responsibility of the Council, in virtue of Article (EC)
    111 and by way of derogation from Article (EC) 300, acting on a
    recommendation of the Commission or the ECB.

  – It must act unanimously if it concerns (i) “conclud[ing] formal
    agreements on an exchange rate system for the ECU in relation to
    non-Community currencies”;

  – by a qualified majority if it concerns (ii) “adopt[ing], adjust[ing]
    or abandon[ing] the central rates of the ECU within the exchange
    rate system”, or (iii) “in the absence of an exchange rate system in
    relation to one or more non-Community currencies Y formulat[ing]
    general orientations for exchange-rate policy”.

  – The ECB must be always be consulted “in an endeavour to reach
    a consensus consistent with the objective of price stability” in the
    first two cases, and “without prejudice to the primary objective of
    the ECB to maintain price stability” in the third case.
                                                                 Slide 67
Exchange Rate Policy
• Fixed Exchange rate policy vis-à-vis Pre-ins
  (ERM 2)
   – participation is voluntary
   – hub and spoke: the Euro is the hub.
   – unlimited intervention by both parties, UNLESS danger
     to price stability
   – actual participants: Denmark, Estonia, Lithuania and
• Exchange rate policy vis-à-vis the Rest of the
   – floating exchange rates
   – external representation of the Euro-area countries (see
                                                        Slide 68
External representation of the Euro-Area countries
“The President of the ECB (replacing the national central bank governors
from the euro area) and the President of the EuroGroup will take part in
the meetings of G7 Finance Ministers when the world economic situation,
multilateral surveillance and exchange rate issues are being discussed. The
Commission will be involved to the extent required to enable it to perform
the role assigned to it by the Treaty, and it will attend the meetings in
connection with specific issues, to be determined by the Ministers.”
Furthermore, the ECB has been granted observer status at the
International Monetary Fund where only the governments are
represented. The Economic and Monetary Union will be represented by
the president of the Euro-area countries assisted by a representative of
the Commission.

                                                                   Slide 69
Macroeconomic Policy
Co-ordination in EMU

                  Slide 70
• Broad Economic Policy Guidelines (BEPG)

• Luxembourg Process

• Cardiff Process

• Cologne Process

• Stability and Growth Pact

                                      Slide 71
         Broad Economic Policy
          Guidelines (BEPGs)
Article 99 (EC):
MS shall regard their economic policies as a matter
  of common concern and shall coordinate them
  within the Council.
The Council shall, acting by a qualified majority on
  a recommendation from the Commission,
    – formulate a draft for the broad guidelines of the
      economic policies of the Member States and of the
    – shall report its findings to the European Council.
                                                       Slide 72
        Broad Economic Policy
         Guidelines (BEPGs)
The European Council shall then
    – discuss a conclusion on the broad guidelines of
      the economic policies of the Member States and
      of the Community.
    – acting by a qualified majority, adopt a
      recommendation setting out these broad
    – shall inform the European Parliament of its
                                                Slide 73
      Broad Economic Policy
       Guidelines (BEPGs)
At present the BEPG serves as co-ordinating
  mechanism for all the processes mentioned
  above as well as the Stability and Growth
Since 2003, the whole process has been
  streamlined, with the Spring European
  Council playing a central role.

                                        Slide 74
 European Employment Strategy

• Essen European Council (1994) called on the
  Labour and Social Affairs and Economic and
  Financial Affairs Councils and the Commission to
   – keep close track of employment trends,
   – monitor the relevant policies of the Member
     States and
   – report annually to the European Council on
     further progress on the employment market,
   starting in December 1995

                                              Slide 75
 European Employment Strategy
• Amsterdam European Council (1997)
  breathed new life into the new strategy
  – established a legal and institutional framework through
    a new employment title in the treaty which declared
    employment a matter of common concern and required
    coordinated action
  – took the political decision not to wait for treaty’s entry
    into force (1 May 1999) to launch the surveillance and
    co-operation procedure on national employment policy
  – agreed to hold a “Jobs Summit”
                                                         Slide 76
    European Employment Strategy
•    The Amsterdam Treaty’s Employment Title
    1. Member States retain main responsibility for
       employment policies, but shall regard promoting
       employment as a matter of common concern and shall
       co-ordinate their action. (Art 126)
    2. All areas of Community policy must take account of
       their impact on employment. The objective of a high
       level of employment has to be taken into account in
       all policy (Art. 127)

                                                     Slide 77
    European Employment Strategy

•    The Amsterdam Treaty’s Employment Title
    3. The Treaty sets up the framework for an annual
       multilateral surveillance procedure, articulated on
       three documents: the annual Employment Guidelines,
       national implementation reports, and the Joint
       Employment Report for submission to the European
       Council every year. (Art. 128)
    4. As an outcome of the joint surveillance, based on
       common employment indicators, the Council may
       issue, upon a proposal from the Commission, specific
       recommendations to individual Member States for
       urgent action. (Art. 128)
                                                      Slide 78
    European Employment Strategy

•    The Amsterdam Treaty’s Employment Title
    5. There is now a legal base for the promotion of
       incentive measures for employment, and for analysis,
       research and exchange of best practice in employment
       policy. (Art. 129)
    6. The Treaty sets up a permanent structure, a new
       Employment Committee, which will play an active
       part in this institutional process and serve as a forum
       for debate on employment issues at European level.
       (Art. 130)

                                                         Slide 79
 European Employment Strategy

• The “Jobs Summit” was held in
  Luxembourg (Nov. 1997)
• Launched the Luxembourg Process
  – annual cycle for implementing and monitoring
    national employment policies
• Introduced the Employment Guidelines
  based on four “pillars”

                                             Slide 80
 European Employment Strategy
• The four “pillars”:
  – Employability - initial employment, maintain
    employment and new jobs,
  – Entrepreneurship – environment for starting
    new business
  – Adaptability - flexible ways of working and of
    organising work,
  – Equal opportunities - equal treatment at work
    and at obtaining one

                                              Slide 81
 European Employment Strategy
• Relies more on co-ordination than on rules
  – because differences between Member States in
    this field are too great to harmonise
• Each MS presents an annual National
  Action Plan that gives content to the four
  “pillars” based on the guidelines.
• Benchmarking
• Peer pressure

                                            Slide 82
The Cardiff Process
• introduced by the Cardiff European Council
  in June 1998
  – to ensure a comprehensive approach to
    structural reforms of goods, services and capital
  – in order to ensure a sustained and durable
    economic growth
  – and to raise employment levels

                                                Slide 83
The Cologne Process
• introduced by the Cologne European Council in
  June 1999
   – introduced the macroeconomic policy guidelines in
     relation to job creation
   – introduced a dialogue on this policy involving the
     social partners alongside the EU's political and
     monetary authorities.
   – key objective: to facilitate enhanced dialogue and
     confidence-building between all actors concerned with
     macroeconomic policy, in order to strengthen Europe's
     ability to boost growth and employment.

                                                      Slide 84
Slide 85
 The New Lisbon Strategy
 • Spring 2005
    – The BEPGs and the EGs will be integrated in an
      Integrated Guidlines Package
       • they cannot be replaced because they are enshrined in the
                   Chapter 1: Introduction
            Part 1                      Part 2
Broad Economic Policy Guidelines Employment Guidelines
           (Art. 99)                  (Art. 128)
  Chapter 2:        Chapter 3:           Chapter 4:
   Macro              Micro            Employment
                  Chapter 5: Conclusions          Slide 86
Slide 87
The Open Method of Co-ordination
• Introduced at the Lisbon European Council
  (March 2000)
• Consists of four elements
   – fixed guidelines set for the Union with short, medium
     and long term goals
   – quantitative and qualitative indicators and benchmarks
   – European guidelines translated into national and
     regional policies and targets
   – periodic monitoring, evaluation and peer review,
     organised as a mutual learning process
• A new method of economic governance ?
                                                       Slide 88
The Stability and Growth Pact

                           Slide 89
Stability and Growth Pact
• Origins of the Pact (to caricature a bit)
  – French considered ESCB statutes a necessary
    evil to bring Germany into a monetary union
  – France wanted a strong countervailing power
  – Germany refused a monetary union without
    some economic convergence
  – Germany wanted rules to maintain fiscal
    discipline once monetary union achieved

                                              Slide 90
The Macroeconomic Role of Fiscal Policy
The Stabilisation Role
• Automatic Fiscal Stabilisers (no gov’t action
   – A rise in output increases tax revenues and decreases
     government expenditures. This dampens the increase
     in output.
   – A fall in output lowers tax revenues and raises
     government expenditures. This increases output.
• Discretionary Fiscal Policy.
   – Policy changes in gov’t. expenditures and/or revenues.
• Cyclically Adjusted Budget Deficits (CAB).
   – Actual budget deficits minus the automatic changes.
                                                     Slide 91
 Why Fiscal Rules?
• Historical Background
  – In the 1980s, there was a large accumulation
    of government debt in most OECD
    countries, which was unprecedented in
  – As a consequence, fiscal sustainability
    became the main fiscal policy issue, and
    major reforms of the fiscal policy
    framework were undertaken in nearly all
    OECD countries.
                                          Slide 92
Slide 93
 The Stability and Growth Pact (SGP)
• Legal Basis
  – Article 99 of the EC Treaty - multilateral surveillance
     • through monitoring of economic policies and the
       publication of Broad Economic Policy Guidelines
  – Article 103 of the EC Treaty – “no bail out” clause
  – Article 104 of the EC Treaty - Excessive Deficit
    Procedure (EDP)
     • procedures for establishing existence of, and taking effective
       action against, excessive deficits and debt levels.
  – Protocol on EDP annexed to the Treaty
     • definition of reference values for excessive government
       budget deficit and debt; and other details.
                                                              Slide 94
 The Stability and Growth Pact (SGP)
• Relevant texts
  – Council Regulation 1466/97 on the strengthening of the
    surveillance of budgetary positions and the surveillance and
    coordination of economic policies [the “preventive arm”]
     • aims, through regular surveillance, at preventing budget deficits
       going above the 3% reference value. Requires the submission of
       stability and convergence programmes.
     • imposes a medium-term objective of a government budget close to
       balance or in surplus
          – measured in cyclically adjusted terms (see Code of Conduct)
  – Council Regulation 1467/97 on speeding up and clarifying
    the implementation of the EDP [the “dissuasive arm”]
     • in the event of the 3% reference value being breached, requires
       Member States to take immediate corrective action, and, if
       necessary, allows for the imposition of sanctions. Council can
       provide an “early warning” of an eventual deficit.          Slide 95
 The Stability and Growth Pact (SFP)
• Relevant texts (cont’d)
  – Council Regulation 3605/93 on the application of
    the Protocol on the EDP (updated: 475/2000,
     • provides precise statistical content to the concepts of
       government budget deficits and debt

  – European Council Resolution on the Stability and
    Growth Pact (Amsterdam, 17 June 1997)
     • a political commitment by all parties involved in the
       SGP to a proper implementation of the budget
                                                         Slide 96
       surveillance process.
 The Stability and Growth Pact (SGP)
• Relevant texts (cont’d)
  – Declaration by ECOFIN Council reaffirming
    commitment to SGP (1 May 1998)

  – Code of Conduct on content and format of stability
    and convergence programmes
     • laid down by Monetary Committee (12 October1998)
       and revised by Economic and Financial Committee
       (EFC) (2001), which replaced the Monetary Committee.

                                                    Slide 97
Stability and Growth Pact (SGP)
• Art. 104.1 Member States shall avoid
  excessive deficits
  – exception: UK (shall endeavour to avoid
    excessive deficits)
• Art. 104.2 specifies the meaning of
  excessive deficits. An excessive deficit
  exists if
  – the ratio of the planned or actual government
    deficit to GDP exceeds a reference value
  – the ratio of government debt to GDP exceeds a
    reference value
                                              Slide 98
Stability and Growth Pact
• The reference values are specified in a
  protocol to the Treaty
  – 3% for the ratio of the planned or actual
    government deficit to GDP at market prices
  – 60% for the ratio of government debt to GDP at
    market prices.
• The concepts are defined statistically in
  Regulation 3605/93 (revised by regulations
  475/2000 and 351/2002)
                                             Slide 99
Stability and Growth Pact
• Art. 104.3 to 6 concern the procedure for
  identifying situations of excessive deficit
• Art. 104.7 to 11 concern the procedure for
  ensuring the correction of excessive deficits
  – Art 104.7 and 8 apply to all EU Member States
  – Art 104.9 to 11 apply only to Euro-area
    Member States
• Art 104.12 concerns the abrogation of the
  EDP when the Member State is deemed to
  have corrected its excessive deficit.
                                            Slide 100
Stability and Growth Pact
Council Regulation 1466/97
  – also known as the “preventive arm”
  – Euro-area MS must submit a pluri-annual
    “stability programme” updated annually
  – the other MS must submit a pluri-annual
    “convergence programme” updated annually
  – the contents are identical
  – the programme should lay down how the MS
    plan to respect the norms laid down in the
    excessive deficit procedure
                                           Slide 101
Stability and Growth Pact
• The programme must
   – include the medium-term objective for a
     budgetary position which is close to balance or
     in surplus
   – indicate the adjustment path towards this
• The Council will decide whether to approve the
  stability programme or to invite the member state
  to adjust it.

                                              Slide 102
Stability and Growth Pact
• The Council will also monitor its implementation
  and may issue recommendations in this context.
• The Council may issue an “early warning” to a
  Member State before an excessive deficit occurs.
• Article 104.2 of the Treaty allows the ratio of the
  planned or actual government deficit to gross
  domestic product to exceed the reference value
  only if this situation is exceptional and temporary

                                               Slide 103
Stability and Growth Pact
• Council Regulation (EC) 1467/97 defines what is
  to be understood by “exceptional and temporary”.
• In particular, it states that an excess over the
  reference value resulting from a severe economic
  downturn will be considered exceptional only if
  there is an annual fall of real GDP of at least 2%.

                                               Slide 104
Stability and Growth Pact
• A smaller decline can only be considered
  exceptional by the Council,
   – on the initiative of the Member State
   – when there is supporting evidence on the
     abruptness of the downturn or on the
     accumulated loss of output relative to past
       • Annual falls of less than 0.75% will not be
         considered as severe
                                              Slide 105
Stability and Growth Pact
• The procedure laid down in Article 104 of the EC Treaty to
  be followed for establishing an excessive deficit is further
  specified in Regulation (EC) 1467/97 which lays down
   – that decisions are taken by (a majority of two thirds of the votes of)
     the Council, excluding (the votes of) the representative of the
     Member State concerned, and acting on a recommendation from
     the Commission.
   – the deadlines that are to be observed
   – the rules for monitoring and assessment of the corrective actions
   – and the eventual application of sanctions if corrective action is not
     taken or deemed unsatisfactory
       • sanctions are applied only to Euro-area members
       • in the event of persistent excessive deficits

                                                                   Slide 106
Stability and Growth Pact
• Sanctions
   – in the first year of sanctions, the MS concerned
     must pay a non-interest bearing deposit equal to
      • fixed component: 0.2% of GDP, plus
      • variable component: 10% of difference
        between deficit and the 3% reference value
      • a ceiling of 0.5% of GDP is set.
   – in subsequent years only the variable
     component is paid
                                               Slide 107
The Stability and Growth Pact in Action
• The SGP entered into force with the start of monetary union
   – 1 July 1998 for Regulation 1466
   – 1 January 1999 for Regulation 1467

• In the lead up to monetary union:
   – there was a great effort made towards “fiscal consolidation”
   – in order to qualify for membership in the monetary union

• Since the start of monetary union
   – there has been a steady relaxation in the effort
   – so that now we appear to be back in 1991 re: fiscal consolidation
                                                             Slide 108
The Stability and Growth Pact in Action
• Portugal
   – 30 January 2002: Commission proposes that an “early warning”
     be issued to Portugal (and Germany) under Regulation 1467/97.
   – 12 February 2002: Council decides not to do so: Portugal profits
     from heavy pressure exerted by Germany.
   – 16 October 2002: Commission issues an opinion that an
     excessive government deficit exists in Portugal. [Art. 104 (5)]
   – 5 November 2002: Council declares that an excessive deficit
     exists in Portugal and recommends action. [Art. 104 (6) and (7)]
   – Portugal acts to remove the excessive deficit
   – Excessive deficit procedure against Portugal was abrogated this
     spring (2004)

                                                             Slide 109
The Stability and Growth Pact in Action
• Germany
  – 30 January 2002: Commission proposes that an “early warning”
    be issued to Germany (and Portugal)
  – 12 February 2002: Council decides not to do so under heavy
    pressure from Germany (pre-election period).
  – 8 January 2003: Commission issues an opinion that an excessive
    government deficit exists in Germany [Art. 104 (5)]
  – 21 January 2003: Council decides that an excessive deficit exists
    in Germany and recommends action [Art. 104 (6) and (7)]
  – 18 November 2003: Commission issues an opinion that
    Germany has not acted on the recommendation and proposes
    legally binding measures [Art. 104 (8) and (9)]
  – 25 November 2003: Commission recommendations do not
    obtain the required qualified majority. Council proceeds further
    (see below) and adopts a set of conclusions put forward by the
    Italian Presidency.                                      Slide 110
The Stability and Growth Pact in Action
• France
  – 21 January 2003: France receives an “early warning” from the
  – 7 May 2003: Commission issues an opinion that an excessive
    government deficit exists in France [Art. 104 (5)]
  – 3 June 2003: Council decides that an excessive deficit exists in
    France and recommends action [Art. 104 (6) and (7)]
  – 21 October 2003: Commission issues an opinion that France has
    not acted on the recommendation and proposes legally binding
    measures. [Art 104 (8) and (9)]
  – 25 November 2003: Commission recommendations do not
    obtain the required qualified majority. Council proceeds further
    (see below) and adopts a set of conclusions put forward by the
    Italian Presidency.                                      Slide 111
The Stability and Growth Pact in Action
• Three elements in the Council proceedings on 25 Nov. 2003:
       • 1. It did not accept the Commission’s Recommendations under
         Article 104 (8) and 104 (9): no qualified majority in favour.
       • 2. It used the voting procedure of Article 104 (9) to vote in a
         new set of conclusions.
       • 3. These conclusions were in the nature of a new
• The Commission sued the Council before the ECJ which
  concluded (in substance) on 13 July 2004 that:
   – The lack of a qualified majority effectively held the “excessive
     deficit procedure” in abeyance till the Commissin proposed a new
   – The Council acted illegally in proposing a new recommendation (a
     prerogative of the Commission)                              Slide 112
Reforming the Stability and Growth Pact
Relevant texts
• “Strengthening Economic Governance and Clarifying the Implementation
  of the Stability and Growth Pact”, Communication of the Commission of 3
  September 2004, COM(2004)581 final.
• “Improving the Implementation of the Stability and Growth Pact”, Council
  report agreed by the ECOFIN Ministers at their extraordinary meeting of
  20 March, and endorsed by the European Council of 22/23 March 2005.
• Proposal for a Council Regulation amending Regulation (EC) No 1466/97
  on the strengthening of the surveillance of budgetary positions and the
  surveillance and coordination of economic policies, (presented by the
  Commission), COM(2005) 154 final, Brussels, 20.4.2005
• Proposal for a Council Regulation amending Regulation (EC) No 1467/97
  on speeding up and clarifying the implementation of the excessive deficit
  procedure (presented by the Commission), COM(2005) 155 final, Brussels,
                                                                  Slide 113
 The Eastern Enlargement of EMU
The new Member States
• are large in population
• but are small in economic terms

                           Population         GDP
                           (millions)   (billion euros)
 New Member States            75              413
 EMU12                     305 (24%)     6828 (6%)
 EU15                      381 (19%)     8843 (5%)

                                                  Slide 114
 The Eastern Enlargement of EMU
Nominal versus fiscal convergence
• Central bank independence and convergence of inflation are prerequisites
  for joining EMU
• These increase the burden for government budgets.
• Budget deficits in many new Member States have increased a lot.
Nominal versus real convergence
• High divergence of real GDP per capita and of price levels
• Economic catch up leads to (Balassa – Samuelson effect)
    – high inflation OR
    – nominal appreciation of the currency
• Making inflation and exchange rate criteria more difficult to realise for
  these countries than for present EMU Member States

                                                                      Slide 115
 The Eastern Enlargement of EMU
 Balassa – Samuelson Effect
Traded goods sector (manufactured goods)
• Economic catch up implies higher productivity growth in traded goods
• Higher productivity leads to higher wages for worker in this sector

Non-traded goods sector (services)
• As labour is mobile between the traded and non-traded goods sectors,
  wages in the services sector rise as well
• But productivity does not increase in the services sector. Consequently,
  prices of services rise. Inflation is higher than in the EU15
• Real convergence (higher productivity growth) conflicts with nominal
  convergence (to a common inflation level)

                                                                     Slide 116