The UK and the €uro Background and Prospects

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The UK and the €uro Background and Prospects Powered By Docstoc
					          After the economic crisis –
             what lessons for the
                European Union
                               Roger Vickerman
                 Dean, Brussels School of International Studies
                              University of Kent




Global Skills Award Lecture
6 December 2010
         Crisis; what crisis?
Saving the euro:
   Dinner on the edge of the abyss
      Tall ambition, flawed foundations
             Bound towards a tense future
                      “Europe will be forged in crises, and will be the
                      sum of the solutions adopted for those crises”
                      Jean Monnet




                                                11-13 October 2010
                                                                          2
    “A quantum leap in the
 governance of the eurozone”?




"We are certainly encouraging governments to go as far as possible in being
commensurate to the challenges. This is true in all domains, quantitative as
well as qualitative. More flexibility in their own capacity to contribute to    3
ensuring that there is financial stability is important.” Jean-Claude Trichet
       What price solidarity?




“If this is the sort of club the euro is becoming, perhaps Germany should
leave” Angela Merkel
                                                                            4
 The Crisis and Economic Coordination
• Crisis shows need for international consensus and
  coordination
• Has the EU failed to achieve this internally and
  externally?
• Would completion of EMU have helped?
• Is the Stability and Growth Pact discredited?
• The ‘one-size fits all’ problem
• Solidarity in the good times and the bad – when is the
  EU not a zero-sum game?
• Why should the UK always appear to be different (and
  difficult)?

                                                       5
                    Overview
• One EU or many?
• Is the EU an Optimal Currency Area?
  – Why do the criteria for joining differ from the economic
    criteria?
  – Is the Eurozone in terminal decline?
• The UK position
  – The UK model of the EU – is it really different?
  – Euro membership: were the ‘5 tests’ a better test than
    the ‘Maastricht criteria’?
• UK economic performance outside the Eurozone
• Origins of the crisis
  – Flawed economics or flawed politics?
• Crisis responses – why only superficial consensus?

                                                         6
                Stages of Integration
• The Free Trade Area
   – no tariff barriers
• The Customs Union
   – FTA + Common External Tariff
• The Common or Single Market
   – CU + Factor Mobility - Non-tariff barriers
• Economic and Monetary Union
   – EU + monetary integration
• Economic Union
   – EMU + harmonisation of economic policies
• Total Integration
   – EMU + harmonisation + fiscal and social integration (implies
     political union?)
                                                                    7
Many Europes




               8
        Why monetary integration?
• Completing the Single Market
• Currencies as non-tariff barriers
   – Transaction costs of exchange
   – Cost of hedging future currency expectations
   – Lack of transparency in prices
• The Single Financial Market
   – Increased efficiency from a single financial sector
   – Common banking rules
   – Common interest rates to avoid market distortions
• Effective macro-stabilisation policies
   – Exchange rates as response to asymmetric shocks
   – Can one interest rate suit all economic situations?   9
 Implications of monetary integration
• Monetary policy and exchange rate regime
   – Fixed exchange rate: no independent monetary policy:
       • money is endogenous
   – Flexible exchange rate: no effect of fiscal policy:
       • the exchange rate offsets fiscal policy effects
• Thus - the inconsistent/impossible trinity
                             Fixed exchange rate




     Full capital mobility                         Monetary policy autonomy
                                Non Eurozone
                                                                              10
    Optimal Currency Area Theory
• Basic question is about exchange rates
  – Flexible exchange rates
     • adjust to cope with asymmetric shocks
  – Fixed exchange rates
     • exchange rates cannot adjust to deal with asymmetric
       shocks/ productivity differentials/inflation differentials
     • adjustment has to come through other markets
     • require common monetary policy
     • thus output/employment adjusts
     • but adjustment less if certain criteria are met

                                                                    11
    Optimal Currency Area Theory
• Six criteria for an OCA                The scoresheet:
   –   Labour mobility (Mundell)           NO
   –   Product diversification (Kenen)     YES
   –   Openness (McKinnon)                 YES
   –   Fiscal transfers                    NO
   –   Homogeneity of preferences          MAYBE
   –   Solidarity                          ???




                                                           12
               Is the EU an OCA?
• Insiders and outsiders
   – the converged, the converging and the unconverged
   – the EU may not be an OCA, but is a subset of the EU an
     OCA?
   – does this imply that some should go it alone (a multi-
     speed union), and does this matter?
   – is the cost of entry too great for some relative to the
     perceived benefits (e.g. Greece, Portugal)
   – does entry lead to uncontrollable problems (e.g. Ireland,
     Spain)
   – does the entry of others subvert economic advantage (e.g.
     Germany, Netherlands, Austria)
                                                            13
          EU Convergence Criteria
• The Maastricht Treaty convergence criteria:
   – the achievement of price stability – a low rate of inflation
     close to the best performing states (defined as being within
     1½ per cent of the average of the three lowest);
   – sustainability of the government financial position – the
     government should not run a financial deficit greater than 3
     per cent of GDP, and gross general government debt should
     be less than 60 per cent of GDP;
   – exchange rate stability – apparent by the observance of the
     normal fluctuation margins provided by the Exchange Rate
     Mechanism, for at least two years; and
   – durability of convergence – convergence of long-term
     interest rates (defined as being within 2 per cent of the
     average long-term interest rate of the three lowest inflation
     states).
• Note how these ‘monetary’ criteria differ from the
  ‘real’ criteria of OCA theory                                 14
               Fiscal implications
• In Eurozone fiscal decisions left to national governments
• But governments can ‘cheat’ on fiscal responsibilities – get
  round tight monetary policy by looser fiscal policy
• Hence need for a mechanism to control cheating – Stability
  and Growth Pact
• SGP has Excessive Deficit Procedure to ‘fine’ miscreants
• But can EDP work effectively if:
   – Slow to initiate
   – Big countries can subvert it
   – Fines make the position of weaker economies even worse
• Need for better early warning system – the ‘Cologne
  process’

                                                              15
              Fiscal Policy in EMU
• Fiscal policy needed to correct “regional” imbalances
• Passive stabilisation through automatic stabiliser
   – tax receipts decline when the economy slows down
   – welfare spending rises when the economy slows down
   – no decision, so no lag: nicely countercyclical
• Active fiscal stabilisation at European level
   – Stability and Growth Pact (SGP): reinforce fiscal compliance
     by member states
   – Excessive Deficit Procedure:
      • 3% GDP deficit limit
      • Allowance for unexpected asymmetric shocks of 2% GDP
      • Breach can lead to “fine” which starts at 0.2 per cent of GDP and
        rises by 0.1 per cent for each 1 per cent of excess deficit up to 0.5%
        GDP
      • But can it be credible? - process takes nearly 12 months and
        requires agreement
                                                                           16
           The deficit bias problem
• Monetary and fiscal policy must be consistent
• Should criteria be relaxed?
   – balance over cycle?
   – political and credibility implications
• Fiscal indiscipline concerns financial markets:
   – raises borrowing costs
   – but markets can distinguish between countries (credit ratings
     affect risk premia)
• More serious is the risk of default in one member
  country:
   – capital outflows and a weak Euro
   – pressure on other governments to help out
   – pressure on the ECB to help out
• The ‘no-bailout’ clause
   – is that any longer credible?
                                                               17
                   The UK in the EU
• Commitment to free trade and single market
• But Single Market implies collective rules
   – Move from unanimity to qualified majority - not liked by UK
   – But increasing size and complexity requires simple rules
   – Democratic deficits?
• Enlargement supported
   – Free trade arguments – the liberal economic argument
   – Makes centralisation more difficult – rejection of the European
     social model
• Reluctance to see deeper integration – the surrender of
  sovereignty
   –   Defence
   –   Justice and home affairs
   –   Borders and visas
   –   Monetary policy
                                                                   18
    The UK question: Euro membership
• UK has satisfied most convergence criteria: not strict
  interpretation of exchange rate
• Two economic sources of UK hesitation to join:
   – Asymmetry in the cycle
   – Mis-valued currency relative to the euro – memory of the ERM experience
• But possible large costs to not joining
   – Transactions costs
   – Trade costs
• But the main objection is political
   – The previous UK (Labour Party) Government was committed to a
     referendum when it decides the time is right to join (on the basis of the 5
     tests) – public opinion suggests that such a referendum would not support
     joining
   – The Conservative Party would probably rule out membership for ever - the
     new Liberal-Conservative coalition has ruled it out for this Parliament (5
     years)
   – And will subject all legislation implying transfer of powers to a referendum
                                                                            19
                            The 5 tests
• Convergence
   – Are business cycles and economic structures compatible so that we and
     others could live comfortably with euro interest rates on a permanent
     basis?
• Flexibility
   – If problems emerge is there sufficient flexibility to deal with them?
• Investment
   – Would joining EMU create better conditions for firms making long-term
     decisions to invest in Britain?
• Financial services
   – What impact would entry into EMU have on the competitive position of
     the UK’s financial services industry, particularly the City’s wholesale
     markets?
• Growth, stability and employment
   – In summary, will joining EMU promote higher growth, stability and a
     lasting increase in jobs?
• The 2003 conclusion
   – Tests 1 and 2 not met, 3 and 4 met; 5 could only be met when 1 and 2 met
                                                                                20
               UK View of the SGP
• A ‘prudent’ interpretation of the SGP needs to take into
  account:
   – the economic cycle
   – sustainability – low debt levels enhance sustainability allowing
     greater room for the automatic stabilisers and providing a basis
     for investment in public services; need to take into account the
     long-term budgetary impact of ageing populations;
   – public investment – public investment contributes to the
     provision of high-quality public services and can help to
     underpin a flexible, high productivity economy.
• Is the SGP now discredited?
   – Failure to enforce excessive deficit procedure
   – Need for greater oversight of domestic fiscal policies?
   – Who pays for mistakes?
                                                                    21
   UK economy outside the Eurozone
• Exchange rate movements
   – stability until crisis?
• Price movements
   – on target relative to ECB?
   – role of Monetary Policy Committee
• Employment and unemployment
   – better performance than Euro zone
• Government debt and deficits
   – better performance than large Eurozone countries
   – until crisis – were there policy mistakes?
• Fiscal rules and the Stability and Growth Pact
   – a difference of opinion about time scales and cycles
   – investment and golden rules
                                                            22
    Historical deficit performance




Source: HM Treasury: Budget 2010


                                     23
           The onset of the Crisis
• The origins of the crisis
   – Financial markets and ‘sophisticated’ instruments
   – Toxic assets and asset price bubbles
   – Who was to blame?
• Has the UK have suffered more? And why?
• How to respond
   – Tax cuts or increased expenditure?
   – On what?
• Who has been more prudent?
   – Scale of public expenditure boost
   – Debt – and who holds it?
• The collapse of world trade and confidence?
                                                         24
                                Warning signs
Bps                         Graph I.1.3:3-month interbank spreads vs T-bills or OIS
500


400                                                                                Def ault of
                                                                                   Lehman Brothers

300
                                              BNP Paribas suspends the
                                              valuation of two mutual f unds
200


100


  0
  Jan-00     Jan-01        Jan-02    Jan-03      Jan-04      Jan-05       Jan-06    Jan-07     Jan-08   Jan-09

                               EUR               USD                  JPY               GBP
Sources: Reuters EcoWin.




                                                                                                                 25
                 Asset price bubbles
                            Graph I.1.7:Stock markets, 2000-09
500                                                                                                                                       300

400
                                                                                                                                          200
300

200
                                                                                                                                          100
100

  0                                                          05.12.03                                                                     0
      03.01.00

                 12.10.00

                            27.07.01

                                       14.05.02

                                                  25.02.03



                                                                        22.09.04

                                                                                   05.07.05

                                                                                              12.04.06

                                                                                                         25.01.07

                                                                                                                    07.11.07

                                                                                                                               22.08.08
                   DJ EURO STOXX (lhs)                                             DJ Emerging Europe STOXX (rhs)

Source: www.stoxx.com




                                                                                                                                                26
    Asset price bubbles




Source: European Commission   27
         The credit crunch




Source: European Commission   28
     Deteriorating public finances
• Spending out of a downturn
• Divergence in the Eurozone
• Failure to accept collective responsibility?
   – The habitual debt offenders: Greece, Belgium, Italy
   – The new deficit offenders: UK, Ireland, Portugal, Spain
   – The prudent offenders: Germany, Netherlands,
     Austria
• Why is the UK involved at all?

                                                          29
            Europe’s fiscal problems
                     Deficit    Debt




Source: European Commission


                                       30
General Government Balance
             2006            2007       2008   2009      2010         2011
    5
    0
   -5
  -10
  -15
  -20
  -25
  -30
  -35

        Belgium       Germany Greece Spain      France   Ireland   Italy   UK

Source: Data from European Commission
                                                                                31
General Government Gross Debt
 180

 160                                                                                  GR

 140

 120                                                                                  IT
                                                                                      IRL
 100                                                                                  BE
                                                                                      FR
                                                                                      UK
   80                                                                                 GE
                                                                                      SP
   60

   40

   20

    0
          2003     2004     2005         2006   2007   2008   2009   2010   2011   2012

 Source: Data from European Commission                                                      32
Public sector deficits


                              Target deficit




Source: European Commission
                                               33
               The consequences
• Unsustainable deficits imply excessive borrowing
• Where borrowing is international has two consequences:
   – Raises cost of borrowing
   – Devalues currency
• But in Eurozone no devaluation option so risk premium
  rises - interest rate spreads on sovereign debt
• In Eurozone speculators lose power to gain from currency
  fluctuations, so speculate on debt: pick off weakest first
  and then move along the row of dominos
• Note this is exactly what happened to the old Exchange
  Rate Mechanism in 1992
• But now net effect is to weaken entire currency
• UK is partially protected as can still offer currency
  fluctuation option – but only up to a point
                                                               34
The sovereign debt problem




    Source: European Commission
                                  35
Divergence in the Eurozone




   Source: European Commission   36
Divergence in the Eurozone


                                But why are Belgium
                                and Italy different
                                from Portugal and
                                Ireland?




  Source: European Commission
                                                      37
     The Irish problem




Source: European Commission   38
The Spanish problem




 Source: European Commission
                               39
USD/EUR Exchange Rate




                        40
EUR/GBP Exchange Rate




                        41
    Real economy consequences
• But isn't this just about money and
  government debts?
• The output costs
  – Less government expenditure
  – Higher borrowing costs
  – Reduced values of wealth
• Affects growth and employment
  – Trade and growth

                                        42
Growth in selected economies




                               43
                         Trade and output




Source: HM Treasury: Budget 2010
                                            44
Growth (% change year on year)
     8
     6
     4
     2
     0
    -2
    -4
    -6
    -8
   -10
           Belgium Germany Greece               Spain     France   Ireland    Italy      UK

                2006        2007         2008      2009      2010      2011       2012
 Source: Data from European Commission

                                                                                              45
 Growth prospects




Source: European Commission
                              46
 Real output costs




Source: European Commission
                              47
                Policy responses
• Spotting the problem:
    – a question of timing
    – what problems – is it like before
    – can we resort to old solutions
•   Is this the real price of globalisation?
•   Who is to blame: deficits vs surpluses
•   Do bail-outs work?
•   Will a European Stability Mechanism work any
    better?


                                                   48
                                                            Policy mix, EU and UK
                                        Graph III.2.1:Macroeconomic policy mix                                                       Graph III.2.2:Macroeconomic policy mix
                                                     in the euro area                                                                         in the United Kingdom

                                            Fiscal tightening/           2006 Fiscal/Monetary                                            Fiscal tightening/
                                                                                                                                                                          2007
                                                                                                                                                                              Fiscal/Monetary
                                        1.0 Monetary easing                         tightening                                       1.5 Monetary easing                            tightening
                                                                2005




                                                                                                  Change in primary balance, % GDP
Change in primary balance, % GDP




                                                                            2007                                                                          2006
                                                              2004                                                                   0.0
                                                                                                                                                                     2005       2004
                                       -0.5                  2003                                                                                             2003
                                                                                                                                     -1.5
                                                           2002
                                                                         2008                                                                     2002
                                                                                                                                     -3.0                                2008
                                       -2.0
                                                                               Fiscal
                                                                              easing/                                                -4.5                                       Fiscal
                                                                            Monetary                                                                                           easing/
                                       -3.5                                                                                               Fiscal/Monetary                    Monetary
                                                          2009             tightening                                                -6.0 easing
                                                                                                                                                                            tightening
                                             Fiscal/Monetary                                                                         -7.5                 2009
                                       -5.0 easing
                                                                                                                                            -4    -3     -2    -1    0      1    2       3
                                            -4    -3   -2    -1      0     1     2      3
                                                                                                                                                 Change in real short-term interest rate
                                                  Change in real short-term interest rate
                                   Source: European Commission                                   Source: European Commission




                                                                                                                                                                                             49
                                           Fiscal stimulus
                                               Graph III.2.7:Fiscal stimulus in 2009

              3
                              Fiscal impulse
             2.5
                              Impact lower extreme: if stimulus is
                              permanent
              2               Impact upper extreme: if stimulus is
  % of GDP




                              temporary and accommodated
             1.5              Impact if stimulus is temporary

              1

             0.5

              0
                   BG DK HU LT LV MA SK CY EE EL IT          NL IE BE FR PT   FI PO CZ EA EU SL LU SE DE UK AT ES US


Note: See Box III.2.1 f or explanation. Source: European Commission.




                                                                                                                       50
Output gap and fiscal stimulus
                                    Graph III.2.9:Output gap and fiscal stimulus
                                                       in 2009


                                   2.5
                                                                                    US
                                                                                      ES
      Fiscal stimulus (% of GDP)


                                    2
                                                                                           AT

                                   1.5                                         UK
                                                                         SE      DE
                                                                    LU              EU SL
                                    1                                             EA                 CZ
                                                                               FI PT FR
                                                                                   BE PO
                                   0.5                  IE                                 NL EL
                                                                               IT
                                                                                                     MA   SK
                                                              LT         DK    HU          BG
                                              EE                                                          CY
                                    0              LV
                                         -9   -8    -7       -6     -5    -4   -3     -2        -1   0    1
                                                                   Output gap, %
    Source: European Commission.

                                                                                                               51
                    Impact of recession on growth
                                                Graph II.1.10:Potential growth by Member State
                4
                                                                                                 BG
                                                                                      SK

                3                                                                RO         LU
                                                                                      PL
2009-2013 (%)




                                                                     CZ
                                                                                CY
                                                                                           SI
                2                                                                                         LT
                                                                                 EL
                                                    AT                                                         EE
                                 DE                        UK               ES
                                          DK BE      NL               FI
                1                    PT                   MT
                                IT                                                                             IE
                                           FR              SE                                                           LV
                                                                           HU

                0
                    0       1                   2               3                     4               5             6        7
        Source: European Commission                                 1999-2008 (%)




                                                                                                                                 52
                          Lessons
• There are benefits, but also costs, to being outside the
  Eurozone - if outside should stay right outside?
• UK felt benefits felt during boom years, but have these led to
  costs later?
• Would Eurozone membership have protected UK from worst
  excesses and their consequences?
• Has the Euro (and the ECB) been a success, and by what
  criteria?
• What about the behaviour of some members? Pressure for
  reform of the SGP?
• Could the ECB (and the European social model) have learned
  anything from the UK experience (and vice versa)?
• What implications for those countries which aspired to Anglo-
  Saxon liberalism and were less able to withstand the pain of its
  readjustment – should there be a dash for Euro-protection?
                                                                53
               Conclusions
• Is this an economic problem, a policy problem
  or a (lack of) solidarity problem
• If so who is to blame?
• Is the cure worse than the disease? And for
  whom?
• Is there a better alternative?
• What about Europe in the world?
• The China question?
                                              54

				
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