THE RUN-UP TO THE RUN-UP TO THE EURO: THE EURO:

THE MAASTRICHT THE MAASTRICHT CRITERIACRITERIA

Week 5Week 5

Chapter 7Chapter 7

THE BASIC CONCEPTTHE BASIC CONCEPT

1) EU: freedom of circulation of capital (“second floor”) and goods/services (“first floor”).

• One affects i, the other affects .2) Which exchange rate regime?• a) Flexible. The resulting high volatility would

have damaged stability, growth, investment.• b) Fixed. In presence of 1), you cannot

accomodate pressures coming from differentials in i and .

• The “inconsistent quartet” : - freedom of circulation of goods/services - freedom of circulation of capital - fixed exchange rate system - independent monetary policy.

YOU HAVE TO GIVE UP ONE OF THEM.• If you fix one price of currency (E) you must

harmonize also the remaining two (i and )

• Coupled with:• a) microeconomic benefits (elimination of

transaction costs, elimination of exchange rate risks)• b) all benefits from second floor (common market)

couldn’t be fully achievable without a single currency (one supermarket, different coins each shop)

• c) foundations of the builiding. If the ultimate objective somewhere down in history is a closer political union (sharing institutions and political legittimacy), maybe we could start by sharing a currency….FEBRUARY 7° 1992, in Maastricht (Netherlands): a decision to adopt a single currency (called “euro” in

December 1995) was formally adopted.

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THE MAASTRICHT CRITERIATHE MAASTRICHT CRITERIA

• What should countries do if they want to adopt a single currency?

• Remember the three prices of the currency:• - interest rate (i)• - inflation rate ()• - exchange rate (E)• Monetary union means to fix irrevocably E, so

some convergence criteria must be needed on the other two.

• In this way, the single currency can be adopted with no consequences on the overall macroeconomic environment.

FIRST CRITERION: INFLATIONFIRST CRITERION: INFLATIONEach candidate country should have an inflation

rate less or equal to the average of three lowest inflation rates in the group of candidate countries plus a 1.5%.

Example:Country A : =3.2%Country B : =2.5%Country C: =4%Country D: =1.7%Country E has to have inflation less or equal to

4.35%.

First reasonFirst reason• 1) We saw that a fixed exchange rate system

cannot be maintained in the presence of strong inflation differentials.

• The resulting pressure on the exchange rate (coming from more/less demand for national goods and services) cannot be accomodated by changing E.

• This is even more true in case of a monetary union, which can be see as the strongest of the fixed exchange rate systems.

Second reasonSecond reason

• Normally, a country has three tools to increase the competitiveness of their exports and compete on markets:

• 1) Improve the quality of their products.• 2) Produce at lower costs, so to sell at lower

prices (i.e. having low inflation).• 3) Use the exchange rate to artificially gain

competiveness (depreciation/devaluation)

• Once in the euro ,3) disappears. 1), we know, it’s not easy. If we don’t set some “common initial conditions”, the race is going to be falsed.

Third reasonThird reason

• Inflation / unemployment trade-off.• In the long-run, unemployment level is not

determined by any nominal or short-term factors; it’s the natural rate of unemployment (corresponding to the natural rate of output/ potential output), determined by:

1) total factor productivity 2) population growthInside 1): R&D expenditure, human capital formation,

macroeconomic and political stability, property right protection, correct functioning of markets……STRUCTURAL FACTORS.

• In the short-run, there is a inflation/unemployment trade off:

• If a country is hit by a negative supply shock on GDP (oil crisis), a central bank faces this choice:

• 1) To stabilize GDP and thus unemployment (by stimulating the economy) and let inflation raise, following the expansionary move.

• 2) To stabilize inflation (by keeping constant / reducing aggregate demand) at the expense of GDP.

• Or any point between these two extremes.• It all depends on the preferences of the central

bank with regard to inflation and unemployment.

• Germany has always had a strong preference for inflation stabilization (hyperinflation in the 20s). German inflation has always been very low, and the Bundesbank acquired reputation of “tough central bank”.

• Italy has always had a strong preference for unemployment stabilization (Southern Italy). As a result, Italy has always had high inflation, and Italian monetary authority has always been considered “soft” on inflation.

• In other words: a country’s inflation rate is an indicator of the central bank’s preferences on the inflation/unemployment trade-off.

• So if countries are about to form a monetary union, they also are about to “merge” their national central banks into one, which will be in charge of managing inflation-unemployment trade off at the EU level.

• So, before merging, they have to agree on which policy stance they are going to have towards inflation.

• They have to harmonize the central banks’preferences, and setting a convergence criteria for inflation is the best way to make sure that each country enters the monetary union (and thus participate in the creation of the common central bank) with the same preferences about inflation.

• REMEMBER BARRO-GORDON FOR A FORMAL TREATMENT.

SECOND CRITERION: INTEREST RATESSECOND CRITERION: INTEREST RATES

Each candidate country must have a long-term interest rate less or equal to the average observed in the three low-inflation countries + 2%

Example:Country A : i=5.21%Country B : i=4.79%Country C: i=6.85%Country D: i=5%(A,B,D are the lowest-inflation countries)Country E has to have inflation less or equal to 7%.

• Excessive long-term interest rate differentials prior to the entry in the EMU can cause large disturbances on financial markets (capital gain/losses).

• Example: suppose UK long-term bond rate is 5% at the moment of joining EMU, while the average long-term bond rate in euro is 4%.

• At the moment of entry, the euro-sterling rate will be fixed irrevocably.

• Since there is no exchange risk involved, bondholders will arbitrage (sell the euro bond and buy the UK bond) until the returns on both are equalized.

• This process will lead to a drop in the price of euro bond and to an increase in the price of sterling bond.

• Those who had euro bonds in their portfolio will make huge capital losses, and those who had sterling bond will make capital gains.

THIRD CRITERION: ECHANGE RATE THIRD CRITERION: ECHANGE RATE STABILITYSTABILITY

Each candidate country should maintain its exchange rates within the 'normal' EMS bands of fluctuation (15% upward and 15% downward) during the two years preceding their entry into the EMU.

Why?In order to avoid artificial manipulation of the

exchange rates so to enter the euro with more favourable conditions (i.e. a country with difficulties in the export sector might be tempted to manipulate markets so to enter EMU with a lower E, so to gain competitiveness)

• For new comers, the relevant exchange rate agreement is the EMS II.

• EMS II is a exchange rate agreement between euro-zone and non-euro EU countries.

• Denmark, Baltic States (Estonia, Lituania, Latvia), Slovakia.

• Slovenia, Ciprus and Malta left EMS II to enter EMU between 2007 and 2008. Slovakia entered in 2009.

• Sweden and UK refused to entry even in the EMS II.

FOURTH CRITERION: PUBLIC FINANCEFOURTH CRITERION: PUBLIC FINANCE

• Consistently with the three-prices view, the first three Maastricht criteria set convergence for:

• - interest rate• - inflation rate• - obviously exchange rates• But this is not enough.• We must ensure that all other variables that

can potentially put pressure on i and are taken care of.

4.1 DEBT/GDP CONVERGENCE4.1 DEBT/GDP CONVERGENCE

• Public deficit = G – T +iB

• Primary public deficit= G-T

• Public debt = stock of bond issued by the government to finance deficit

• What’s the connection between those variables and interest rate or inflation?

• High debt puts upward pressure on:

• 1) inflation rate• 2) interest rateAnd thus indirectly violates criteria 1 and 2.

Why?

DEBT-INFLATIONDEBT-INFLATION

• High-indebted government have a strong incentive NOT to fight inflation.

• Inflation benefits borrowers and damages lenders, because it erodes the real value of the loan.

• If I borrow 100 euro at 4% interest rate, if inflation goes up from 1% to 3% I only give back 101 in real terms.

• Who is the biggest borrower in the economy?• The government, when issue public debt.• So high-indebted government have incentive to

“inflate the debt away”, and this is in contrast with the first criterion.

DEBT-INTEREST RATEDEBT-INTEREST RATE

• 1) When the government issues more debt, it puts upward pressure on the interest rate in the capital market, since demand for funds increases (and so the price of money increases).

• 2) It also increases the interest rate via the increase in the risk premium; since the debt exposure increases, financial investors will require a higher return (interest rate) in order to protect themselves from default risk.

ABSOLUTE OR RELATIVE VALUES?ABSOLUTE OR RELATIVE VALUES?

• We are not interested in absolute values (B or D).• We are interested in relative values (B/GDP, D/GDP).• Family A and Family B both own 15.000 euro.• Family A’s annual income is 30.000 euro.• Family B’s annual income is 150.000 euro.• Which one is in deeper trouble?• Family A, because it is indebted for 50% of their income,

whereas family B only for 10%.

• So, Family A’s situation is more dangerous, because their debt exposure is higher with respect to their capability to pay the debt back.

FAMILIES OR COUNTRIES?FAMILIES OR COUNTRIES?

• The equivalent for countries….• DEBT/GDP DEFICIT/GDP• The stock of debt (or the deficit flow) compared to

a country’s income.• This measure also suggest an alternative way to

improve public finances: not only to decrease the numerator (issuing less debt / reducing deficit byspending less or taxing more), but also to increase the denominator will work.

• Namely….promote GDP growth!

FOURTH CRITERION: PART 1FOURTH CRITERION: PART 1

• Each candidate country should have a government debt less or equal to 60% of GDP. If this condition is not satisfied, government debt should diminish sufficiently and approach the reference value at a satisfactory pace.

• Why 60% ? • Because it was the average value of debt/GDP

ratios of member states at that time.• Italy and Belgium benefited from the clause.

FOURTH CRITERION:PART 2FOURTH CRITERION:PART 2• Each candidate country must have a deficit/GDP

ratio less or equal to 3%.• Why 3%?

• d= deficit / GDP (D/Y)• b= debt/ GDP (B/Y)• g= rate of growth of GDP

1t t

gd b

g

to stabilize b=60%to stabilize b=60%

0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.080

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tasso di crescita del Pil nominale

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in presenza di una crescita nominale del 5%

If I have d=3%If I have d=3%

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SO….SO….• A deficit / GDP limit of 3% succeeds in stabilizing

debt/GDP at 60% ONLY IF nominal growth of GDP is at least 5%.

• Real growth = nominal growth – price growth• Real growth= nominal growth – inflation• With a inflation target=2%• THE FOURTH MAASTRICHT CRITERIA IS BASED ON

THE ASSUMPTION OF REAL GROWTH OF OUTPUT = 3%

• And, obviously, on the desire to stabilize debt/GDP ratio at the average level of EMU member states (60%).

• When we look at the Stability and Growth Pact (week 6 and 7), we will analyse the consequences of this ambitious assumption about the growth capabilities of European national economies.

AFTER SPRING BREAKAFTER SPRING BREAK• Maastricht criteria and EMU enlargement

YOUR PRESENTATIONS ON COUNTRIES’REPORTS

• SGP AND ITS REFORM• COMMON FISCAL POLICY

• THE EURO AND THE FINANCIAL MARKET