17 European Monetary Unification and the Euro

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17 European Monetary Unification

and the Euro

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News: Mar 17-23

• _{Eurozone leaders agree on system to handle failing banks -- NYT:}_3/20_|_Proquest

– _{Political leaders from the European Parliament, from member states, and from the European Commission agreed on}

a system for sharing funds to be used for shutting down failing banks in a crisis. This is a step toward a "banking union" that has been a goal of many since the financial crisis.

– _{The problem has been that, because banks have been regulated only within the nations of the eurozone, yet the}

banks themselves often operate throughout Europe, a bank failure both overwhelms the resources of its national government and creates strains on other banks that might then also fail.

– _{The new system, which will require banks to contribute to a central fund run by a Resolution Board and overseen by}

the European Central Bank, should be able to fully manage the failure of a bank within a weekend.

• _{Zambia drops two regulations on foreign currency exchange -- FT: 3/21 |}_CTools

– _{One regulation, now dropped, stopped businesses from paying for goods and services in dollars. The second, also}

dropped, forced exporting companies to repatriate any foreign currency that they earned.

– _{Dropping these regulations is a response to the 13% fall this year in the value of Zambia's currency, the kwacha,}

relative to the US dollar. The fall was due mainly to a fall in the world price of copper, which accounts for 70% of its export earnings.

– _{The hope is that dropping these regulations, which had discouraged foreign investors, will stop the decline of the}

currency. Of course the regulations themselves had been a misguided attempt to support the currency.

• _{Students and others in Taiwan protest trade agreement with China -- NYT: 3/19 |}_Proquest

– _{The agreement would reduce barriers to trade in services, as a follow-up to a 2010 Economic Cooperation}

Agreement. The ruling party in Taiwan, which negotiated the deal, has the votes to approve it, but the agreement is not popular with the public.

– _{Hundreds of people -- students and others -- occupied the Taiwan's legislature and demonstrated outside to protest}

the trade agreement, objecting that it will reduce Taiwan's independence from China.

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News: Mar 17-23

• _{Eurozone leaders agree on system to handle failing banks}

– _{Political leaders from the European Parliament, from member states,}

and from the European Commission agreed on a system for sharing

funds to be used for shutting down failing banks in a crisis. This is a step toward a "banking union" that has been a goal of many since the

financial crisis.

– _{The problem has been that, because banks have been regulated only}

within the nations of the eurozone, yet the banks themselves often operate throughout Europe, a bank failure both overwhelms the

resources of its national government and creates strains on other banks that might then also fail.

– _{The new system, which will require banks to contribute to a central fund}

run by a Resolution Board and overseen by the European Central Bank, should be able to fully manage the failure of a bank within a weekend.

(4)

News: Mar 17-23

• _{Zambia drops two regulations on foreign currency exchange}

– _{One regulation, now dropped, stopped businesses from paying for}

goods and services in dollars. The second, also dropped, forced

exporting companies to repatriate any foreign currency that they earned.

– _{Dropping these regulations is a response to the 13% fall this year in the}

value of Zambia's currency, the kwacha, relative to the US dollar. The fall was due mainly to a fall in the world price of copper, which accounts for 70% of its export earnings.

– _{The hope is that dropping these regulations, which had discouraged}

foreign investors, will stop the decline of the currency. Of course the regulations themselves had been a misguided attempt to support the currency.

(5)

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News: Mar 17-23

• _{Students and others in Taiwan protest trade agreement with China}

– _{The agreement would reduce barriers to trade in services, as a}

follow-up to a 2010 Economic Cooperation Agreement. The ruling party in Taiwan, which negotiated the deal, has the votes to approve it, but the agreement is not popular with the public.

– _{Hundreds of people -- students and others -- occupied the Taiwan's}

legislature and demonstrated outside to protest the trade agreement, objecting that it will reduce Taiwan's independence from China.

– _{China officially views Taiwan as still a part of China and insists that}

eventually the two parts of China must be reunified.

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Announcements

• _{Exam next week: Wed Apr 2}

– _{Not cumulative}

– _{More details next time, but it’s much like 1}st exam

•

Questionnaire: Please respond to course questionnaire

– See link in the announcement yesterday – Or go to course website “Take Winter 2014”

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Econ 340, Deardorff, Lecture 17: 9

Outline: European Monetary

Unification and the Euro

• _{What Is It?}

• _{History of the EMU}

• _{Need for Convergence}

• _{Pros and Cons of Unification}

– _{Why Adjustment Is Hard}

– _{Winners and Losers under EMU}

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What Is It?

• _{The move to a common currency for a}

group of countries of Europe

– _{Originally 12 countries}

– _{Now 18, with addition of Latvia Jan 1 2014}

• _{Purpose: To further the economic}

integration of Europe that

– _{Began with the European Economic}

Community (a customs union – see next time)

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Euro Zone

Members

Plus

Latvia

2014

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What Is It?

• _{The currency is shared by all 18 countries}

and is not controlled by any one of them

• _{It is controlled by the European Central}

Bank (ECB), based in Frankfurt, Germany

• _{The group of countries is called the}

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Outline: European Monetary

Unification and the Euro

• _{What Is It?}

• _{History of the EMU}

• _{Need for Convergence}

• _{Pros and Cons of Unification}

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History of the EMU

• _{Before 1973:}

– _{All these currencies were pegged to the US}

dollar

• _{After 1973:}

– _{The Bretton-Woods system collapsed and}

major currencies stopped pegging to US$

– _{By default, currencies began to float}

– _{Europe, because of its large trade, found}

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History of the EMU

• _{After 1973:}

– _{Europe tried several arrangements to get}

greater stability

• _{Wide-band peg to $ with narrower peg to each}

other: “Snake in the tunnel”

E

time

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History of the EMU

• _{After 1973:}

– _{Europe tried several arrangements to get}

greater stability

• _{Narrow peg to each other with no peg to $:}

“Floating snake”

E

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History of the EMU

• ₁₉₇₉

– _{European Monetary System (EMS) established}

– _Features:

• _{An Exchange Rate Mechanism (ERM) of exchange}

rates pegged to each other within ±2.25% bands

• _{Provision for adjusting the pegs when needed}

• _{A basket of currencies forming the European Currency Unit}

(ECU) that floated with respect to outside currencies

• _{Capital controls}

– _{Did it work?}

• _{Inflation rates differed, but their differentials gradually fell} • _{11 currency realignments during 1979-87}

Much like Bretton

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History of the EMU

• _{1989: First official statement of the goal of}

moving toward a common currency

• _{1991, December: Maastricht Treaty}

– _{Agreement on greater unification of member}

countries, forming the “European Union”

– _{Also included the terms for adopting the}

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History of the EMU

• _{1992: Crisis}

– _{Denmark voted NO to the Maastricht Treaty}

– _{Speculative attacks on currencies forced some to}

drop out of ERM

• _1993:

– _{ERM widened bands to ±15%}

– _{Prospects for EMU looked bleak}

– _{Denmark ratified Treaty but “opted out” of the euro;}

UK also opted out

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Outline: European Monetary

Unification and the Euro

• _{What Is It?}

• _{History of the EMU}

• _{Need for Convergence}

• _{Pros and Cons of Unification}

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Need for Convergence

• _{Difficulties of adopting common currency}

– _{If countries have different rates of inflation}

• _{High-inflation countries will lose markets to low-inflation}

countries

• _{Exchange rates won’t adjust (}_{a la}_{PPP) to correct for}

differences

– _{If countries have different interest rates}

• _{Capital will flow to high-interest rate countries seeking higher}

return

• _{Uncertainty about exchange rate won’t offset this}

– _{Temptation to run budget deficits when able to borrow}

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Need for Convergence

• _{Difficulties of adopting common currency}

– _{These suggest that success with a common}

currency requires countries to have similar

• _{Inflation rates}

• _{Interest rates}

• _{Budget deficits}

• _{Government debts}

– _{Achieving this was called “convergence” and}

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Need for Convergence

• _{Maastricht Convergence Criteria}

1. National currency in ERM for 2 years 2. Budget deficit < 3% of GDP

3. Government debt < 60% of GDP

4. Inflation < 1.5% above average of lowest 3 5. Long-term interest rates < 2% above

average of lowest 3

• _{How well were they doing?}

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Maintaining Convergence

• _{Stability and Growth Pact (SGP)}

– _{Agreed in 1996 that members of the}

Eurozone would

• _{Keep their budget deficits below 3% of GDP}

• _{Pay fines if they broke this limit}

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Timetable

• _{May 1998: Membership was set}

– _{Based on convergence}

– _{All of the then 15 EU members, except}

• _{UK, Denmark, Sweden – who opted out}

• _{Greece – who failed to converge (Greece did enter soon after)}

• _{Jan 1, 1999: Euro launched (except notes/coins)}

– _{Value of euro = 1 ECU as of midnight Dec 31, 1998 = $1.18} – _{Currencies “irrevocably” linked}

– _{Single monetary policy: ECB (European Central Bank)} – _{New public debt issued in euros}

– _{Financial markets started using euro}

• _{Jan 1, 2002: Notes/coins started circulating}

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The euro notes and coins

• _{Note what does not appear:}

– _People

– _{Actual buildings and places}

• _{Purpose was to treat all members equally}

• _{Result was that the currency lacks personality}

• _{People don’t much like it, and they miss their old}

national currencies.

• _{See Kulish}

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Members

• _{As of 2002, EU had 15 members, of whom}

12 adopted the euro

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Members

• _{Since 2002, the Eurozone has become:}

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Outline: European Monetary

Unification and the Euro

• _{What Is It?}

• _{History of the EMU}

• _{Need for Convergence}

• _{Pros and Cons of Unification}

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Pros and Cons of Unification

• _{Proponents expected}

– _{Complete the internal market}

– _{Improved competition & efficiency}

– _{Arbitrage across national borders}

– _{New era of prosperity}

– _{Stable prices}

– _{Fiscal discipline}

– _{Lower interest rate}

_{thus higher investment}

_{Stronger growth}

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Pros and Cons of Unification

• _{Opponents expected}

– _{Division of the EU (baffling pigs vs. duks)}

– _{Loss of sovereignty}

– _{Little popular support}

– _{Regulatory & other costs}

– _{Difficulties of adjustment to asymmetric}

shocks

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Outline: European Monetary

Unification and the Euro

• _{What Is It?}

• _{History of the EMU}

• _{Need for Convergence}

• _{Pros and Cons of Unification}

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Pros and Cons of Unification

• _{Why adjustment is hard}

– _{Like states in the US, countries in Eurozone}

have

• _{No exchange-rate tool}

• _{No separate monetary policies}

• _{Very limited fiscal policies (due to SGP)}

– _{Unlike US states, however}

• _{Labor is less mobile across countries}

• _{Wages are less flexible, due to social policies}

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Pros and Cons of Unification

• _{Without adjustment}

– _{When one country is hit with a shock that}

others are not (an “asymmetric shock”),

• _{Its markets don’t adjust (rigid wages)}

• _{Its people don’t move}

• _{It has fewer policies to deal with this}

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Outline: European Monetary

Unification and the Euro

• _{What Is It?}

• _{History of the EMU}

• _{Need for Convergence}

• _{Pros and Cons of Unification}

(43)

Winners and Losers from EMU

• _Winners

– _{Multinational companies: their costs of operating in}

multiple countries were reduced

– _{Europe’s biggest banks were expected to gain,}

through consolidation across borders

– _{Consumers, able to comparison-shop across borders}

• _Losers

– _{Small firms (e.g. shops, restaurants), for whom}

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Outline: European Monetary

Unification and the Euro

• _{What Is It?}

• _{History of the EMU}

• _{Need for Convergence}

• _{Pros and Cons of Unification}

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What Happened?

• _{Euro started (Jan 1, 1999) at 1.18 $/€}

• _{Now (Mar 16, 2014) it is 1.39 $/€}

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What Happened?

• _{Euro fell, after its creation by about 25% to 2001}

• _{Then it rose by 2004 back to slightly above}

where it started

• _{By 2008 it had risen to over $1.50, only to fall in}

2009

• _{Today, it is about 18% above where it started}

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What Happened?

• _{Has it worked well for Europe?}

– _{There were problems, even in the early years}

• _{Many in Europe perceived that prices rose when}

converted to euros

• _{Several countries broke the limit of the SGP}

– _{Portugal: suffered criticism but was not fined} – _{France, Germany}

» _{Too big even to criticize}

» _{Instead EU revised the SGP}

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What Happened?

• _{The problem of Greece (started in 2010)}

– _{Greek government deficits have been over 10% of}

GDP

• _{(compare SGP limit of 3%)}

– _{Greek debt rose to about 160% of GDP}

• _{(compare SGP limit of 60%)}

– _{Markets feared default; speculators attacked both}

Greek bonds & euro

– _{EU (esp Germany) were reluctant to help (& was}

prohibited by Lisbon Treaty)

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What Happened?

• _{The Euro Zone today}

– _{The debt crisis spread to other countries}

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What Happened?

– _{In process of negotiating a mechanism to}

• _{Provide loans to member countries in trouble}

• _{Put pressure on them for austerity:}

– _{Cut spending} – _{Raise taxes}

• _{Form “banking union” to safely manage bank}

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What Happened?

– _{Still trying to solve the problem of Greek debt}

(See Forelle & Walker)

• _{Tradeoff between}

– _{Bailout money from others to pay it off}

» _{Favored by weaker EU countries (e.g., France)} – _{Cutting value of bonds to private sector holders}

» _{Called “haircut” (also “bail-in”)}

» _{Also, “Private-sector involvement” (PSI)}

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What Happened?

– _{Fear that if not solved,}

• _{Greece will default}

• _{Speculators will attack other weak countries’ bonds}

– _Portugal – _Ireland – _Spain – _Italy

• _{Greece and others will be forced to leave the euro}

– _{These concerns seem to have abated lately}

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What Happened?

• _{Has the euro mattered for the US?}

– _{Not much}

– _{When the euro fell initially it made it hard for}

US to compete

– _{In 2007-8, with euro’s rise,}

• _{US benefited as sellers}

• _{Hurt as consumers and as tourists}

– _{There is talk of central banks switching from}

dollars to euros as reserves

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Next Time

• _{Preferential Trading Arrangements and the}

NAFTA

– _{What are they?}

– _{Their effects}

– _NAFTA